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MAR 2020


11-Year Bull Market Felled by Coronavirus

Feifei Li

Feifei Li, Head of Equities, reiterates that even before coronavirus fears triggered the market downturn, Research Affiliates’ expected return models indicated a zero 10-year real return for US large caps. Will returns move into negative territory? Stay up to date with Research Affiliates Asset Allocation Interactive tool.

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Vonnie Quinn (0:00): We are joined by Feifei Li, Research Affiliates’ head of equities, from Newport Beach, California... Thanks, Feifei, let me come to you first and ask you, is this the end of the bull market? Are we seeing a protracted bear market here? Or is this a panic scenario?

Feifei Li: So certainly we expect a very significant slowdown in global economic growth. And if not handled well, this can trigger a recession in the equity market as well. I wouldn't make a definite call at this moment. But even before the coronavirus outbreak, Research Affiliates’ expected return model, which looks at long-term indicators such as the Shiller P/E, which is the ratio of price to the cyclically adjusted 10-year average earnings at the beginning of year, was warning of extremely high valuations at 31. At the end of last week, the Shiller P/E was at 28. Both are significantly higher than the historical norm. The historical average P/E is around 16 to 17. So, we know the equity market was priced too high even before the outbreak, and the equilibrium seems to be fragile. In such a scenario, typically some event, big and sharp, could totally shake it or even destroy the equilibrium. So I think coronavirus may be what makes the market correct. And we do think the market has further room to adjust downward.

Vonnie (1:33): Are we in danger, Feifei, of seeing credit markets seize up like we did in 2008?

Feifei (1:39): Yes, I think that's a potential problem. When the economy slows down there are several factors to consider on both the consumption side and the production side.  On the consumption side we have already observed weakness due to travel bans impacting the airline industry, lodging industry, anything related with travel. Large events are being called off. Sporting events have been canceled. We don't know whether the Summer Olympics will occur in Japan. So those kind of things really hurt the consumption side of business spending and consumer spending.

On the production side we have noticed that at the end of February, China's PMI, or Purchasing Managers’ Index, was at 40 and new orders at 35. Again, both of these measures were down further than the lowest level during the global financial crisis. And we know China leads the global manufacturing cycle, so this disruption in the supply chain is likely to spill over to the rest of the developed world and will slow down economic growth. As a result of the slow down and disruption in consumer and business spending, banks and financial companies will be under significant pressure.

Vonnie: Feifei, let me come back to you and ask you if you anticipate that we'll see a wave of bankruptcies because obviously, when things are this extreme, it's not that long before companies start to fold and before confidence gets lost. And if that's the case, who needs to step in here?  Does it need to be the Treasury Secretary? Does it need to be the Fed again?

Feifei (7:35): The Fed has already taken action to try to save the economy and, yes, supply chain disruption will likely cause further closures of business in the US and in the rest of the developed world. Likely a surge in unemployment rates is a big risk along the horizon. That's why I said, if not handled well, this could trigger a recession. Coronavirus is just the triggering event. Going forward, I think the Fed is running low on ammo. The Fed funds target rate is already around one percentage point, but I think it can still go lower. Actually, the futures market has already priced in a very high probability of a further reduction in rates at the March meeting by 50 basis points and another reduction in April. So likely within the first half of 2020, the Fed will lower the rate close to zero.

Guy Johnson (8:37):  Feifei, are we priced for a recession now?

Feifei (8:41): That's a really good question. Again, I would focus on the long-term expected return model developed by Research Affiliates. Basically, we look at dividend yield. We look at capital growth, as well as valuation change. Based on our recent forecast coming out at the end of February, we expect the US large-cap market to deliver close to a zero real return over the next 10 years. This is a decade-long forecast. So if we focus on a short horizon, I would say if recession is actually hitting us over the next six months, the return can enter a negative regime.

Vonnie: All right. Feifei Li with Research Affiliates joining us there from Newport Beach. Thank you.