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Investment sanity checks as Covid-19 fears take over
THE Covid-19 fear has finally become official. For the longest time, global financial markets remained an oasis of calm despite the escalating virus outbreak situation in Asia. This alluded to the common perception that the outbreak remained largely an Asia-centric affair. But the calm has since given way to fear, with news of rising infections in other parts of the developed world, such as Italy and South Korea.
Barring the outbreak becoming a global pandemic, I do not expect the negative impact on financial markets to be long-lasting. Governments in Asia have stepped up their response to counter the impact on trade and sectors such as tourism. For instance, the People's Bank of China has injected more than US$200 billion into money markets and lowered its interest rates on reverse repurchase agreements.
Our analysis has shown that most investors, including long term pension, insurance, endowment and sovereign wealth funds, have in the past years missed out on this 12-year-old bull market.
Hence, the dynamic of 'fear of missing out' will result in equity markets being supported. And with the ultra-low rates we see today - the 30-year US Treasury yield falling to a historic low of below 2 per cent and the junk-rated Greek government bond trading through 1 per cent - there is no real alternative to equities as an asset class.
Instead of attempting to second-guess how the virus outbreak will evolve from here, I also took a back-of-the-envelope look at how much economic damage arising from the outbreak has been priced in by the market, based on prevailing prices.
Sanity checks: have the negatives been sufficiently priced in?
Sanity check (1)
Bonds - What has been priced in? The bond market has moved in response to the Covid-19 virus, where yields have fallen sharply. In the fixed income market, the US Treasury 10-year yield has plunged to a low of 1.3 per cent amid the flight to safety. From the historical correlation between Treasury yields and ISM Manufacturing, 1.3 per cent yield would infer an ISM index of 47, a level which points to a contracting manufacturing sector.
Sanity check (2)
Equities - What has been priced in? Stock markets have fallen more than 10 per cent, similarly factoring in a sharp economic slowdown. This has led to US equity valuation reverting to its long-term average of 17X.
My view is that the negatives have been sufficiently priced in. Oftentimes, trying to gauge what is encapsulated in a price of a risk asset is more art than science. This time is no different. Our analysis provides me with a reasonable basis to conclude that the market might be looking oversold on the belief that the US economy is not teetering towards a recession - given the strength of the domestic economy as reflected in the abundance of jobs and the historically low unemployment rate.
How should investors position their portfolios in this transitory headwind?
Build a resilient portfolio for the long term.
In this time of slower growth and low interest rates, I reiterate the Barbell Strategy - that is to build resilience in your portfolio in two areas of focus, namely bond-like securities that will generate superior income, and stocks that can ride on long-term secular growth trends.
For the income end of the Barbell Strategy, I favour corporate bonds especially in the BB/BBB-rated segment. They offer an attractive risk-reward compared to the low yielding A/AA-rated or riskier B/CCC-rated bonds.
Given the very low rates today, I view dividend-yielding equities as the new bond proxies. My preferred sectors are Europe oil majors, China large banks and Singapore Reits where their high dividend pay-outs, I believe are sustainable.
On growth assets, lean on long-term, irreversible growth themes. As the world transforms into a digital economy, stay positive on technology stocks including cloud computing, semiconductors and e-commerce.
Healthcare and millennial consumption themes are beneficiaries of today's demographics.
When selecting stocks to buy for your portfolio, look for "IDEA" companies - the companies that are recognised as the Innovators, Disruptors, Enablers, or Adapters of their industries. These companies will be big winners in this fast-changing world we live in.
Stay positive on China
Despite the impact of the outbreak in China, I believe large state-owned banks and e-commerce stocks still hold great value. Large banks offer attractive dividend yields and will be beneficiaries of the government's policy stimulus. Revenue outlook among e-commerce companies is likely to remain robust and resilient in this environment.
Keep the faith
Market volatility is inevitable, especially as our world faces more challenges. However, I am sure that by investing with the long-term horizon in mind, making smart tactical moves in the short term, and seeking companies and regions with great growth potential will bear investors fruit in the long run.
- The writer is chief investment officer of DBS Bank.