March MAST Asset Allocation Outlook: Too Much "Corona" Spoils the Party

While closely monitoring the evolution of COVID-19, our view that the economic damages from the virus will be largely transitory is intact.
March 2020
  • The evolution of the coronavirus will be crucial for markets in coming weeks, but central-bank easing will help cushion against further fear. We continue to expect a transitory impact from the virus without a full blown pandemic, but volatility and uncertainty are expected to linger a few more weeks.
  • Rate cuts won’t cure the virus, but they make equities increasingly attractive as yields remain under downward pressure. Bond markets might force the Fed and other central banks to additional easing in coming weeks.
  • We remain cautiously optimistic about the outlook, maintaining a moderate overweight to stocks versus bonds. Bond yields are fast approaching zero in North America, but we are not calling for a bottom yet and we are keeping a small overweight to duration.
  • We are tactically overweighting Emerging Markets (EM) stocks in light of China’s quick containment to the virus. Fiscal and monetary easing will provide a substantial tailwind to EM stocks in coming months. We are funding our EM overweight with Canadian stocks, whose bank heavy index should lag EM stocks in this Chinese reflationary cycle.

Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his…Sad to say, the poor fellow has incurable emotional problems.

Warren Buffett

Too Much "Corona" Spoils the Party

Late February, early signs of the virus spreading globally triggered a severe selloff in equity markets and yields on government debt collapsed. Meanwhile, high-frequency Chinese indicators such as daily coal consumption and road traffic were showing a gradual rebound in activity. Europe is starting to feel the pain as Chinese tourism has collapsed while the spreading of the virus has put parts of Italy under lock down. Although the virus has gone global, the rate of contagion appears to have tapered off (Source: World Meters). But it remains unclear how severe the infection rate could evolve in Europe and North America, which matters most to investors. Although on average 400,000 people die of the flu every year (Source: NCBI), Coronavirus (COVID-19) has raised several unknowns and fear.

China has managed to contain the spreading of COVID-19 quite rapidly and the drastic measures to contain the spreading have been largely successful. For instance, the Guangdong region, with a population of about 110 million, has seen less than 1500 confirmed cases and 7 deaths as of March 4 (Source: CHP), which means a very low 0.001% infection rate.

Less than a week after Fed Vice Chair Clarida said policy is at a “good place” (Source: Bloomberg), the “Fed-put” was triggered on the morning of March 3 with a 50 basis point (bps) emergency rate cut. While it won’t cure the virus, we believe lower interest rates are making equities even more attractive. Unwinding these rate cuts is likely to prove more difficult than delivering them.

February Downhill for Stocks

Solid earnings and optimism had stocks off to a good start in February, but the avalanche of Coronavirus bad news sent stocks on a steep downhill late in the month. The VIX volatility index came just shy of hitting 50 on February 28th, the highest since the 2008 financial crisis (Figure 1). Global stocks (MSCI ACWI) fell 8.0% on broad regional weakness as investors braced for a major COVID-19 induced economic slowdown and earnings contraction in 20H1. Interestingly, while Italy was the epicenter of the virus spreading across developed economies, its stock market (FTSE MIB, -5.6%) outperformed the main European benchmark (Euro Stoxx 50, -8.5%). Because fear drove global market sentiment, there was little dispersion across major markets, with losses ranging between 8 and 9%. Canada (S&P TSX, -5.9%), EM (MSCI EM, -5.3%) and Nasdaq 100 (-5.8%) stocks stood out with slightly less negative performance. The key outlier last month was China’s main benchmark (Shenzhen, +2.8%), which climbed for a second month in a row, confirming that investors expect the drag on Chinese growth and earnings to be short lived.

Figure 1: VIX Implied Volatility Index Spikes on Corona Fear

Too Much Corona Spoils the Party - Figure 1 - VIX Implied Volatility Index Spikes on Coronavirus Fear

Source: BMO Global Asset Management, Bloomberg.

There was plenty of action in fixed-income markets as well with investors flocking to bonds on expectations that central banks would come to the rescue. In Canada, the yield on 10-yr government bonds fell another 14bps last month, and is down by over 85bps year-to-date as of early March following the Bank of Canada (BoC) rate cut, with the yield even trading below 0.9%. That’s roughly 1.5% below CPI inflation, which makes fixed-income assets increasingly difficult to hold in the long run for investors concerned about preserving purchasing power. The loonie continued to depreciate against the USD (-1.2%) as oil prices tumbled another 13.2% after a similar drop in January. With elevated fear in markets, the U.S. dollar (DXY) gained another 0.8%. Lastly, corporate credit spreads of U.S. high-yielding debt widen by 110bps as recession fears rose.

Equity Factors: Value stocks getting a little cheaper, again

Equity factors suffered evenly in February, but Value (-9.2%) was consistent by underperforming Momentum (-7.0%), Growth (-7.0%) and Quality (-7.4%) again. Small-cap (-9.3%) and High-Dividend (9.1%) stocks also suffered more than the broad market (MSCI AWCI, -8.0%).

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, -5.5%)* slightly outperformed the broad market BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN, -5.8%)* for the second month in a row. Our view of strategically and tactically overweighting Canadian Low-Vol stocks is intact even though we believe the drag from the coronavirus will be largely transitory.

Are Small-Cap Stocks Another Value Trap?

Small-cap equities have attractive long-term performance with a persistent risk premium attached to them, largely because large investors face capacity constraints when investing in that space. Small-cap stocks tend behave similar to Value stocks and usually outperform during economic upturns because smaller companies can be more nimble at capturing emerging growth opportunities. They are also less sensitive to interest rates, but they are more volatile and tend to significantly underperform during market corrections. Finally, late-cycle or low-growth environments are not an ideal time to overweight them vs large caps as investors start to focus on firms with quality attributes.

Since October 2018, which marked the beginning of the end to the Fed’s rate cycle after Fed Chair Powell’s “long way from neutral” comment, large and small cap returns have diverged significantly (Figure 2). U.S. small-cap equities (Russell 2000) have underperformed large caps (S&P 500) by about 16%. In Canada, the small-cap underperformance is a bit worse. Globally, Canadian small caps have underperformed partly due to their higher share of energy companies, which have struggled intensely in recent months. During times of heightened uncertainty, overweighting of large vs small caps can be a good hedge to downside risks as smaller companies tend to have more difficulty navigating through periods of financial stress. This is especially true amid the coronavirus flare-up which is disruptive to supply chains and cash-flow streams.

Figure 2: Large- vs Small-Cap Stock Performance

Too Much Corona Spoils the Party - Figure 2 - Large- vs Small-Cap Stock Performance

Source: BMO Global Asset Management, Bloomberg. Data as of March 5, 2020.

Fed Outlook: Emergency rate cuts, “Panic-at-the-Disco” or prevention?

On the day the Fed delivered a 50bps emergency rate cut (Source: Bloomberg), equity markets closed down nearly 3% as investors wondered whether the Fed knew something they didn’t. In our view, rather than signalling acute fears of a downturn, the move is another sign that the Fed is preemptively acting against downside risks. When rates are near the zero lower bound, central banks are better off shooting fast and hard instead of delivering gun-shy 25bps cuts at every second meeting while “waiting for the data”, as economists too often do.

Given that the short-term economic outlook remains clouded by the fear of the coronavirus and that central bankers remain dedicated to extend the cycle at all cost, we could see more rate cuts soon. With interest rates in negative territory, the ECB and Bank of Japan will likely rely on other “tools” to support markets, notably by expanding their asset purchasing programs.

BoC Outlook: Coronavirus does not hide lingering domestic headwinds

After being an outlier in 2019, the BoC echoed the Fed to safeguard against the ongoing corona drag with a 50bps rate cut (Source: Bloomberg). Given the cooling of growth in 2019 and how persistently inverted the Canadian yield curve has been, the cut was probably a little overdue even though we continue to think Canada needs a more supply-driven, pro-growth fiscal policy. What is certain is that household indebtedness will increase by fueling an already hot housing market. In this context, we expect Real Estate Investment Trusts (REITs) to continue outperforming banks until the downward pressure on interest rates stabilizes later this year.

Super Tuesday: Good news for stock investors

Joe Biden made a surprisingly big comeback on Super Tuesday. After biting the dust against Bernie Sanders, markets were reassured by his performance that gave him the lead to win the Democratic nomination. Biden has a long track record of centrist policies, in stark contrast to Sanders’ advocacy for substantial government control of key economic sectors such as healthcare and energy. Rising odds of a Sanders candidacy was also weighing on equity markets in late February. Pricing out this risk will be an important cushion for North American equities and helps to reinforce our U.S. overweight view.

Outlook and Positioning: Low rates will push investors to riskier assets

While closely monitoring the evolution of COVID-19, our view that the economic damages from the virus will be largely transitory is intact. The recent sell-off in equities, coupled with the sharp fall in interest rates (Figure 3), leaves us maintaining a moderate overweight to stocks versus bonds, hedged with a small overweight to duration. We continue to expect U.S. stocks to outperform EAFE while preferring safer investment grades corporate bond to riskier and higher-yielding debt. In light of China’s positive response to contain the virus along with the Phase-One deal, we tactically overweighted EM stocks, which we funded by reducing Canadian stocks on expectations EM will outperform in coming months.

Figure 3: Interest Rates Racing to Zero

Too Much Corona Spoils the Party - Figure 3 - Interest Rates Racing to Zero

Source: BMO Global Asset Management, Bloomberg.

The loonie has weakened by over 3% this year, but to break below 0.72 cents we would need to see a direct impact on Canada from the virus, which we think remains a small risk for now. We expect housing momentum to accelerate heading into the spring buying season, but collapsing oil prices will weigh on Canadian growth and the loonie.


*The performance for (ZLB) for the period ended February 28th, 2020 is as follows: 8.87% (1 Year); 8.01% (3 year); 7.14% (5 year); and 12.83% since inception (on October 21st, 2011).

*The performance for (ZCN) for the period ended February 28th, 2020 is as follows: 4.88% (1 Year); 4.96% (3 year); 4.40% (5 year); 6.03% (10 year); and 6.53% since inception (on May 29th, 2009).

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