Investment implications of the coronavirus correction

Current market volatility, as most market observers are acutely aware, is due to the spread of the coronavirus and fears of a global pandemic. The economic and market risks presented by this crisis are material and shouldn’t be underestimated. But as investors, it’s crucial to see that high-quality bonds are acting as equity hedges while defensive equity allocations are acting as diversifiers. 

Moving into 2020, two of our top defensive asset allocation ideas in a broader portfolio context were U.S. investment-grade bonds and global infrastructure-related equities—with the latter sourced from international equity allocations. We’ve been pleased with the resiliency of these areas of the market amid the recent sell-off of most risk assets.

As we discuss in Market Intelligence, our broader asset allocation views have been to lean into U.S. relative to international stocks, emphasize mid and large caps over small caps, and favor high-quality over high-yield bonds. Based on the macro data we’re monitoring, we haven’t changed our views. If anything, the recent downside risk to global growth from the coronavirus has increased our conviction in these calls. 

However, some areas where we might’ve expected more strength have so far displayed greater weakness. Most notably, high-quality U.S. stocks have been pulled down by the indiscriminate selling that’s developed across global markets. We believe that quality stocks with higher return on equity, better relative margins, and lower debt to equity would outperform their lower-quality peers in a relatively subdued global growth environment. We think this thesis still holds, and we view the recent modest underperformance of higher-quality names as a potential opportunity for investors who are looking to allocate cash or buy on the dip.

Trying to call the exact bottom is a futile exercise, but we’re looking at the recent sell-off opportunistically. Valuations on U.S. equities had become stretched at the start of 2020, and today’s pullback in stocks has reduced the price-to-earnings ratio (P/E) on the S&P 500 Index. We’d reached as high as 19x forward earnings in the beginning of February this year—the highest level since 2002. But as of February 26, the forward P/E ratio fell to 17.5x. That’s not cheap by historical standards, but a valuation re-rating lower may eventually attract buyers.