Research Market strategy
By Swissquote Analysts
Themes Trading

Dare chasing a dip?

By Ipek Ozkardeskaya
Published on

Equities in Wall Street fell 15% off a historical high reached on 11 February, as news that the coronavirus outbreak may threaten the world economy, and not just through China, hit the headlines with the rapid spread of the infection in Asia, the US, Latin America and Europe.

On Wednesday, the World Health Organization (WHO) announced that cases outside China exceeded cases inside for the first time since the beginning of the outbreak. Containment measures are being taken outside China and include broad travel restrictions and quarantines.

As such, recent news suggests that the expectation of coronavirus cases would die out by the end of this month has become a wishful thinking. A global pandemic may be knocking on every continent’s door.

The sell-off in the market is the reflection of several factors.

First, activity in China has picked up in February, but slower than what many expected. Chinese businesses will probably accelerate their working pace during March, but the first two months of the year have been mostly ‘lost’.

While the Lunar Year break is a time of cyclical, planned slowdown in industrial production and trade in Asia, the continuation of subdued activity following holidays will soon translate into abnormally depressed numbers and deterioration in data may be worse than many expect.

Second, the subdued production and demand in China, had a severe impact on many multinationals’ supply chains. Big names including Apple sent out a warning that they won’t hit their first quarter targets.

Third, and the most worryingly, it looks like other parts of the world are now on the verge of experiencing the outbreak. Hence, depending on how fast the infection spreads, businesses outside China may need to take similar containment measures, in which case, Covid-19 could paralyze economic activity for additional weeks, and maybe months throughout the globe.

And finally, the panic.

Goldman Sachs forecasts that the impact of the coronavirus will be a 0.8 percentage point drag down on the US growth, and a 3.4 percentage point decline in China ‘to 2.5% yoy before a rebound to 6.8% yoy by year-end, leaving full-year 2020 growth at 5.5%, but view risk to these forecasts as skewed to the downside’.

Such dramatic slowdown in global growth will hit company earnings at least during the first quarter of 2020.

Big banks lowered their forecasts. Bank of America Merrill Lynch warned that it could be the worst year since 2009, Goldman Sachs said it expects no profit growth for the US companies and J.P. Morgan downgraded its profit estimates for the S&P500.

So, the equity rout we see today is not a standard downside correction of a preceding market rally. It is more than that. There is a significant downside revision in earnings expectations and the revaluation could be further deepened if investors take into account the significant divergence between stock prices and their underlying profits over the past years. In fact, the last time stock prices deviated this much from their underlying profits, it was the dot.com crisis.

But good news is that the disconnect between market prices and fundamentals is a well-known fact. It has been boosted by ultra-lose monetary policies over more than a decade. Therefore, investors also know that as long as the Federal Reserve and other central banks keep pushing liquidity into the market, a significant part of this additional cash would feed into the stock markets. There is no other place it could go.

Hence, investors know that if all goes wrong, they can still turn to the central banks.

This is what is happening right now.

The US 10-year Treasury yield dived to a record low below the 1.20% this week. It is somewhat amusing to see the US yields at historically low yields, given that the stock prices were hitting record after record until last week and the Fed has recently stated that the US economy is ‘in a good place’.

Anyway, activity on the Fed funds futures predict two interest rate cuts from the Fed before November. The first cut could happen as soon as the FOMC’s March meeting. Activity on US sovereign bonds market points that the probability of a March cut spiked during this week’s heavy market sell-off.

Though we believe that the Fed would rather wait a couple of hard data points before curbing its rates, the severity of the actual panic could push the policymakers to act before it gets too late.

So, if there is one thing that could save the US stocks from falling further, it is a timely Fed intervention. History shows that regardless of the gravity of shocks, the US stock markets always managed to come out victorious, with the support of the Fed.

Hence, buying the dip could be an opportunity to jump on the back of a Fed-driven bull. Yet, only investors with solid nerves would get rewarded in such a bold trading environment.