Chaos can create opportunities

Bottoming is a process, but we see signs that risk-off positioning is getting extreme

Heading into 2020, the global economy was showing signs of stabilizing and risk assets were benefiting from the cyclical rebound in activity.

In recent months, however, the coronavirus has delivered a significant external shock to Chinese and global economic activity at a vulnerable stage of the business cycle.

Meanwhile, markets are reacting to the contagion and associated loss of output with a dramatic repricing of risk across a wide array of assets.

The S&P 500 Index has fallen almost 30% from its all-time high in February,1 culminating in the highest percentage increase in equity volatility of the cycle and in the history of the Chicago Board of Options Exchange (CBOE) Volatility Index (VIX).

Both the price of West Texas Intermediate (WTI) crude oil and the S&P 500 Energy sector have skidded over 60% from their year-to-date highs in January2 (another significant exogenous shock to the economy at a weak point in the cycle), raising grave concerns about the fundamental health of energy producers.

High-yield corporate bond spreads above their government counterparts have widened to levels not seen since 2015 to 2016, the last major dislocation in oil prices and energy stocks.

Are we trading ourselves into an economic recession? Is this becoming a self-fulfilling prophecy?

For economists, those are serious questions worth considering. If the 2015-2016 experience is any guide, we could at least be facing an energy-led contraction in business spending and corporate profits.

Are there any mitigating forces, short of a cure or vaccine for the virus, that could help soften the blow?

First, what I think is bad for US energy producers — a much smaller share of gross domestic product (GDP) — is good for US energy consumers — a much larger share of GDP. For example, lower oil prices lead to lower retail gasoline prices, eventually freeing up money in consumer pocketbooks for spending, saving, or paying down debt.

Second, the 10-year Treasury bond yield — which has bounced off its nearby low — remains well below its high for the year.3 The associated decline in mortgage interest rates has sparked a surge in refinancing activity, which should ultimately liberate additional household cashflow.

Third, monetary and fiscal authorities around the planet have responded rapidly to the associated tightening of financial conditions, doing their part to help avoid a potential credit crunch by cutting interest rates, expanding asset purchases, injecting liquidity, and appropriating funds to fight the outbreak. Indeed, Congress has agreed on another round of substantial fiscal stimulus.

For market strategists, the answer to whether we’re facing a recession is academic. Certain market segments such as bonds and defensive equity sectors are behaving like the economy is already contracting.

Under the circumstances, investor risk-off positioning is understandable. However, in my view, it has become so lopsided that it’s inconsistent with the current pace of business activity in the US.

From a contrarian perspective, equities and cyclical sectors of the market are so out of favor that they’re becoming interesting again. Contrastingly, bonds and defensive equity sectors seem stretched.

What does heightened turbulence mean for future returns on stocks?

Since 2008, we’ve seen four equity volatility spikes above 70%. Encouragingly, 12-month forward returns were positive from each episode (excluding the current experience), with a median return of 8%.4

In other words, I believe near-term chaos can create long-term opportunities for patient investors.

To be clear, bottoming is a process and virus-related uncertainty could continue to weigh on markets until the number of new cases outside of China peaks and/or the fiscal response becomes coordinated and forceful.

However, indications of excessive caution in the marketplace suggest savvy investors may start looking for opportunities to be contrarian when others are fearful.

1 Source: Bloomberg, L.P. as of March 18, 2020

2 Source: Bloomberg, L.P. as of March 18, 2020

3 Source: Bloomberg, L.P. as of March 18, 2020

4 Source: Bloomberg, L.P., Invesco as of March 13, 2020

Important information

Blog header image: Justin Pumfrey / Getty

Risk off refers to price behavior driven by changes in investor risk tolerance; investors tend toward lower-risk investments when they perceive risk as high.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.

The ISM Manufacturing PMIwhich is based on Institute of Supply Management surveys of manufacturing firms in the US, monitors employment, production, inventories, new orders and supplier deliveries.

Credit spread (bonds) is the difference in yield between bonds of similar maturity but with different credit quality.

NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The opinions referenced above are those of the author as of March 19, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

Invesco Distributors, Inc.

Talley Léger is an Investment Strategist for the Global Thought Leadership team. In this role, he is responsible for formulating and communicating macro and investment insights, with a focus on equities. Mr. Léger is involved with macro research, cross-market strategy, and equity strategy.

Mr. Léger joined Invesco when the firm combined with OppenheimerFunds in 2019. At OppenheimerFunds, he was an equity strategist. Prior to Oppenheimer Funds, he was the founder of Macro Vision Research and held strategist roles at Barclays Capital, ISI, Merrill Lynch, RBC Capital Markets, and Brown Brothers Harriman. Mr. Léger has been in the industry since 2001.

He is the co-author of the revised second edition of the book, From Bear to Bull with ETFs. Mr. Léger has been a guest columnist for The Big Picture and for “Data Watch” on Bloomberg Brief, as well as a contributing author on Seeking Alpha (seekingalpha.com). He has been quoted in The Associated Press, Barron’s, Bloomberg, Business Week, Dow Jones Newswires, The Financial Times, MarketWatch, Morningstar magazine, The New York Times, and The Wall Street Journal. Mr. Léger has appeared on Bloomberg TV, Canada’s BNN Bloomberg, CNBC, Reuters TV, The Street, and Yahoo! Finance, and has spoken on Bloomberg Radio.

Mr. Léger earned an MS degree in financial economics and a Bachelor of Music from Boston University. He is a member of the Global Interdependence Center (GIC) and holds the Series 7 registration.

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