Investment Insights
By: J. Reed Murphy, CIO
Contributions by: Rob Young, CFA
Equity markets sold off on Monday, primarily on renewed concerns around the Coronavirus (COVID-19) as reported cases outside of China increased over the weekend. European markets were down (MSCI Europe was down 3.72%). The S&P 500 was down 3.35% to close at the same point when it hit a year-to-date low at 3,225 on January 31st following the first reaction to the virus. Ironically, China’s stock market was more resilient (Hang Seng was down 1.8%), perhaps based on a decline in new case trends and powerful responses from the government. While the markets had essentially shrugged off much of the coronavirus concerns, we thought an update is warranted.
What is Coronavirus (COVID-19)?
According to the World Health Organization (WHO), Coronavirus is a virus that can cause a cough, tiredness, fever and a severe acute respiratory syndrome (aka SARS). According to the WHO, elderly people and those with heart conditions or immune deficiencies are more exposed to deadly outcomes. This particular strand is similar to the SARS virus of 2002/03. However, it is more contagious, but much less deadly. This strand has been named COVID-19.
It is also informative to compare COVID-19 to the common flu. According to the World Health Organization, “these annual epidemics are estimated to result in about 3 to 5 million cases of severe illness, and about 290,000 to 650,000 respiratory deaths annually.”
Watching the Outbreak
As exhibit 1 shows, there have been 79,331 confirmed global outbreaks as of February 24, 2020. China accounts for 77,262 (97.4%) of those with 64,287 (81% of global total) coming just from the Chinese province of Hubei. China and the Hubei province have accounted for 99.1% and 95.3% of the total global fatalities (2,618). Despite the low relative numbers, an uptick in reports in Korea, Iran and Italy over the weekend caused investors to wake up Monday morning eager to sell stocks. Korea now has 763 reported cases, while Japan has 144, Italy 124 and Iran 43. Unfortunately, there are 695 reported cases on international boating vessels.
The news of these additional outbreaks outside of China has markets nervous after essentially shrugging off – particularly in the U.S. - concerns over the past four to six weeks. Markets will continue to watch the report of cases. Historically, markets have rebounded once trends in reported cases peak and start declining, which they have in China.
While the level of reports does not seem as serious as the normal flu, what is causing concern is the new and unknown nature of the virus, which results in governments shutting down commerce and quarantining or locking down towns, cities or regions.
Exhibit 1: Tracking Recorded Cases –Largely Focused in China
Source: World Health Organization
Economic Reports May Bring More Concern
We fully expect economic news out of China to be soft. Estimates are that China will have missed 13 of 70 working days in the first quarter of this year as the government shut down business and quarantined regions. According to Evercore International Strategy & Investments (ISI), they are expecting a potential -14% quarterly (year-over-year) decline in GDP. This will translate to a dip in GDP growth for the year below the 6%-handle target. Naturally, this will impact supply chains and other economies and markets. For example, Germany’s economy is heavily reliant on exports to China/Asia. More specifically on the domestic front, S&P companies only report 6% of revenues from China.
On the positive side, Chinese employees are being sent back to work and the government is stepping up with stimulus, albeit patiently. As the People’s Bank of China’s vice-governor Chen Yulu wrote last week, policymakers believe the most likely scenario is a “V-shaped” recovery as “postponed consumption and investment activities resume.”
According to Zacks, “estimates are still only calling for a relatively small impact on the U.S. economy (just two tenths of one percent off of Q1 GDP, and maybe another two tenths later in the year)”. Regarding fundamentals, prior to this outbreak economic news included a bottoming and uptick in economic conditions globally. Central banks were very accommodative and have telegraphed they will be even more so if conditions warrant.
As a result, markets to-date have looked through this and responded well. However, as virus reports outside of China increase and economic reports start to come public, we must be prepared for more volatility. As the following exhibit illustrates, we have been immune to daily returns of 2% or more (positive or negative) in recent times and certainly well below historical averages.
Exhibit 2: S&P 500 Volatility Has Been Relatively Benign in Recent Years
Source: Bloomberg. Data as of February 24, 2020. Past performance is no guarantee of future results.
The current base case by economists and market strategists account for a pause in consumption versus a more permanent trend. A relevant question, therefore, may be whether a recovery is more of a U-shaped dip or a V-shaped one. As we suggested in our paper, Coronavirus in Context published in late January, markets should eventually return to bigger economic fundamental news. And, using historical epidemics or pandemics as a reference, markets tend to rebound from symptoms.
Exhibit 3: The S&P 500 Index Tends to Look Past Historical Outbreaks
Epidemics and Pandemic episodes sourced by MarketWatch and Strategas to capture a fuller dataset. Returns calculated from month-end of publicly available outbreak dates. Sources: Bloomberg. Past performance is no guarantee of future results; Initial outbreak dates source: Asian Flu: Encyclopedia Britannica; Hong Hong Flu: Encyclopedia Britannica; India Smallpox: World Health Organization; HIV/AIDS: CDC; Pneumonic Plague: CDC; SARS: Wikipedia; Avian Flu: Wikipedia; Denigue Fever: NDTV; Swine Flue: CDC; Cholera: Foreign Policy, MERS; CDC; Ebola: New England Journal of Medicine; Measles/Rubeola: CDC; Zika: NPR; Measles/Rubeola: Discover.
The Importance of Diversification
While equity markets were down on Monday, the 10-year U.S. Treasury yield drifted down to 1.37% from 1.92% at the beginning of the year and 1.47% on Friday (February 21). This means bonds should serve portfolios well as bond prices go up when interest rates go down.
Here are a few other portfolio construction reminders that should be helpful for broadly diversified, balanced investors.
- International Equities – As we discussed in our recent paper, Why International?, we believe active management is important when allocating to international equities.
- Domestic Equities - Many of our clients have defensive allocations within their domestic equity allocations.
- Global Infrastructure - This asset class also has defensive properties that we highlighted in a recent topic paper titled, Global Infrastructure Investments.
- Bonds - Bonds, specifically treasuries, serve as a “safe haven” asset during choppy markets.
- Convertibles - Provide a good diversifier and risk-adjusted profile. When volatility rises, the relative performance of convertibles tends to improve historically.
- Market-Neutral Strategies - These strategies tend to have historically lower correlations to both stocks and bonds, potentially providing good diversification with downside protection.
What to do?
While we do not yet know the full reach and impact of COVID-19, we do know that emotional reactions at this point would be based on unknowns and speculation. While the S&P 500 may drift lower amid this period, it is also important to note that economic fundamentals are good and central banks are ready to keep stimulating.
We will continue to monitor this situation and provide more context as events warrant. Stay tuned.