LONDON (Reuters Breakingviews) - Global markets are in full-on fear mode. The FTSE 100 Index fell as much as 4.3% in morning trading on Friday, echoing a similar drop in the U.S. S&P 500 Index on Thursday. The immediate and obvious cause is evidence that the coronavirus spreading rapidly outside China. But beyond the panic investors are also wrestling with two big questions.
The current maelstrom is hitting stock markets at a vulnerable time. Valuations are stretched: even after this week’s bloodbath, the Russell 1000 Index of big U.S. companies is valued at 17 times expected earnings for the next 12 months, according to FTSE Russell. That’s higher than the average multiple of 15.6 times over the last decade, and well above the 14 times reached following a selloff induced by fears of a recession in late 2018. With the exception of the United Kingdom and Japan, stocks outside the United States are also still trading above their 10-year averages.
Whether shares fall further rests on what the current demand slump does to corporate earnings – the denominator in the valuation metric. The 13% drop in the MSCI All Country World Index since Feb. 12 represents around $7 trillion of lost value. At the average multiple over the past three months, that’s equivalent to $420 billion of lost earnings, or about 15% of the total expected for the next 12 months. If the coronavirus weighs on the global economy for the first half of the year, rather than just the first quarter, the impact on companies’ bottom lines may be bigger.
Optimists can console themselves with the idea that economic activity – and corporate profitability – will quickly snap back when the virus eventually recedes. A similar logic applies in markets for commodities like crude oil and copper, which have respectively fallen 20% and 10% since mid-January, but are waiting for market players like the Organization of the Petroleum Exporting Countries to cut supply.
A bigger concern is that the scale and severity of the coronavirus could lead to a more fundamental fragmenting of fragile global supply chains, which are currently inextricably linked to China. That could entail a permanent hit to profit margins. If investors believe that a temporary impact on earnings is becoming structural, the current correction will have a lot further to go.
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