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How much further will markets fall as Covid-19 spreads?

As uncertainty increases over future growth, investors may turn more risk-averse and demand a higher premium, leading to lower company valuations and affecting market prices.

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At the end of March 3, the authors' model-based macroeconomic analysis indicates that US equities could drop a further 11 per cent.

THE novel coronavirus Covid-19 has now spread to dozens of countries - at steep human cost - and many equity markets recently recorded their worst short-term losses since 2008. But how much further could markets drop? The answer may depend on growth expectations and the degree of risk aversion adopted by market participants.

We used a new macroeconomic model to estimate the market effects of a severe but plausible short-term downside scenario. At the end of March 3, our model-based macroeconomic analysis indicates that US equities could drop a further 11 per cent. Meanwhile, our stress-testing analysis says that a well-diversified 60/40 portfolio could lose approximately 7 per cent: In this scenario, global equities could lose slightly more than 10 per cent - while Treasury bonds could gain 2 per cent, offsetting some of the equity losses.

How could a pandemic impact the macroeconomy?

The global spread of Covid-19 is already affecting global growth. Disruptions in the global supply chain and decreased consumption affect companies' earnings in the short term. Combined supply and demand shocks could lead to a severe short-term decrease in GDP growth. It is less clear whether the coronavirus will have long-lasting effects. A sustained crisis could, for example, lead to persistent changes in global supply chains, contributing to a partial reversal of global trade and how companies conduct their businesses.

Chart 1 compares a short-term shock only (blue) with a combination of short- and long-term shocks (green). While the short-term scenario leads to only a one-time drop in output - after which we return to a normal growth regime - the long-term scenario leads to persistently lower growth. The latter could have significant implications for future equity-market performance.

But there is a further driver for financial markets. As uncertainty increases over future growth, investors may turn more risk-averse and demand a higher premium to compensate them for the additional risk they are taking on. If they do so, they would discount future earnings more aggressively and lower companies' valuations, affecting market prices.

Implications for markets

How much room is there for further losses in the near term? In our scenario, we assume short-term growth drops by 2 percentage points and the equity risk premium increases by 2 percentage points in response to heightened uncertainty about long-term growth. Based on those assumptions, our model indicates the potential for a 22 per cent drop in the US equity market in the near term, relative to a baseline scenario without the growth and risk-premium shocks, according to our model.

To see the potential short-term impact on a global multi-asset-class portfolio, we created a stress test using MSCI's predictive stress-testing framework to propagate our main assumptions to all other risk factors impacting portfolio returns. We assume that US equities could drop 22 per cent in the near term, relative to a baseline scenario. We also assume that the 10-year Treasury yield could drop by 90 basis points (bps); US investment-grade credit spreads could widen by 60 bps; and high-yield credit spreads could widen by 200 bps.

Under this scenario, our stress test shows that a 60/40 model portfolio could lose approximately 12 per cent and global equities could lose slightly less than 20 per cent compared to the baseline scenario - while Treasury bonds could gain 6 per cent, offsetting some of the equity losses. Both corporate investment-grade and high-yield bonds could suffer market-value losses as credit spreads widen, but those losses could be partially offset by the decrease in yields. The market has already reflected some of the changes; as of the end of trading on March 3, this hypothetical portfolio could drop 7 per cent under our scenario.

If the global economy suffers only short-term pain, the market could bounce back once the shockwave of uncertainty dissipates, according to our analysis. However, if long-term growth - and as a result, corporate earnings - took on a lower trajectory due to the pandemic, the market impact could be felt over a much longer horizon. By 2030, our model shows that the cumulative impact on US equity could improve to -3 per cent (from -22 per cent) with only a short-term shock, but could rebound to only -10 per cent with both short- and long-term shocks, as we can see in Chart 3.

As the Covid-19 spreads across the globe, investors are assessing the potential impact on the economy and their portfolios. As we show in our stress test, there is still room to fall for both US equities and a global diversified portfolio. A longer-term shock could have more severe implications.

  • Thomas Verbraken is Executive Director, Risk Management Solutions Research, MSCI
  • Chenlu Zhou is Executive Director, Multi-Asset Class Factor Research Team, MSCI
  • Juan Sampieri is Senior Associate, Portfolio Management Research, MSCI

The authors thank Rodrigo Gil for his contribution to this article.