Markets Grapple with the Coronavirus
There’s an old saying that markets take the escalator up and the elevator down. That sure was the case this week. Selling pressure was intense all week as investors grappled with the implications of the coronavirus spreading beyond China’s boarders. The S&P officially hit correction territory with a decline of more than 10% from the high. As you can see below, this is the eighth correction of more than 10% since the bull market began in 2009. We have now had 26 instances where the S&P has fallen by more than 5% since March 2009.
Another way to look at it is in the chart below. This doesn’t show all the major corrections, but sometimes the visual is a little easier to internalize.
So far, the correction in the S&P is roughly in line with the average since 1980. The bars shows each year’s return while the dots show the biggest sell-off that year. The average correction comes out to -13.7% over this period, but obviously the range is large.
What’s different this time around is that the correction has happened quickly. Just 6 days. This is the fastest in history, as you can see below.
I’m not sure if this has something to do with the nature of the virus or the nature of our economy/media/trading structure. But there is something to the idea that markets seem to move much quicker than they did a couple decades ago.
At the opposite extreme, bond yields continued to push lower as investors fled to the safety of fixed income. The yield on the 10-year Treasury fell from 1.47% last Friday to all time low levels of 1.16% Friday morning. Overseas the yield on the German 10-year fell to -0.59%. Intermediate-term Treasury bonds were up +2.5% for the week as of Friday morning.
So, where does this leave investors in a typical 60/40 portfolio as of Thursday’s close? Down roughly -4% YTD, as you can see below. The losses on the equity side YTD have been partially offset by gains in both short-term and intermediate-term bonds.
How to Price in the Unknowable?
Markets are essentially discounting mechanisms – they try to price in what the future holds. They generally do a good job for run-of-the-mill type things like new product launches or interest rate changes, although they are far from perfect. But throw something at it that is essentially unquantifiable and things go a bit haywire.
This is where we stand with the coronavirus. How do you price in something that you can’t realistically model? Where the difference between the worst case and the best case is so extreme?
There are no easy answers here. The main bearish triggers this week were:
– The COVID-19 virus is now global in nature. For example, new cases in South Korea are growing more rapidly than in China.
– In the U.S. the director of the CDC’s respiratory illness division stated that the coronavirus will soon grip the U.S. She was quoted as saying “It’s not a question of if this will happen, but when this will happen, and how many people in his country will have severe illnesses.”
– Unlike SARS, the COVID-19 coronavirus appears to be extremely contagious and can be spread by people who show few or no symptoms.
– A case was reported in Solano County that, at least so far, can’t be traced to overseas travel. Governor Newsom said 8,400 people in California are being monitored.
– Japan closed all schools until the school year ends in late March.
Of course, there are other data points, but this captures the spirit of the headlines. It is worth pointing out that there are some positive data points that haven’t received much attention yet:
– The growth in the number of new cases appears to be slowing (orange line below), and of the 84K confirmed cases, 37K people have recovered (green line below).
– The decline in the number of new infections in China suggests that the virus can be contained, provided that governments are both able and willing to impose severe quarantine measures on their own citizens.
– China is actually slowly going back to work, hopefully foreshadowing what happens in the rest of the world over the coming months.
What’s the Economic Impact?
This is both an easy and hard question to answer. The easy answer is that the impact will be bad. But how bad? This is where economists struggle because they have to take human psychology into account. Will people quit travelling? How will impaired supply chains impact production? Will consumer spending dry up if people choose to stay home? Or will Amazon and Netflix gain even more market share as consumers buy from home. Let’s DoorDash instead of going out to eat?
No easy answers to any of these, and a myriad other questions. A few general thoughts:
1) The economic ramifications of the virus are for the most part related to public health countermeasures, rather than to fatalities or sickness.
2) The principal distinguishing characteristic of COVID-19 is that carriers are contagious long before symptoms are present, which implies that quarantine countermeasures must be applied early and with draconian efficiency. The latter implies a harsh hit to economic activity.
3) Clearly global growth will be very weak, if not negative, in the first quarter. The questions that investors are grappling with are really twofold; a) how long till infection rates peak globally, and b) once they peak, how quickly will growth rebound?
On the last point there is no clear answer yet. There are numerous opinions floating around, but in reality, all speculations at this point are simply guesses.
We think a key question investors must ask themselves is how does the current situation impact long-term business valuations? At the end of the day, if you are invested in stocks today you own a stream of cash flows from real businesses. As Warren Buffett often points out – stock ownership = business ownership. The team at Oakmark funds made an interesting point this week that is often lost in the media noise – a stock’s true value comes from estimated future cash flows discounted back to today. As Oakmark points out:
“…(this) means the typical company will generate 4%-5% of its current market cap in 2020 cash. Mathematically, most of the total value of a growing company comes from the aggregate cash it will generate in the years 2023-2050 and beyond.
If 2020 cash flows for the entire market dropped all the way to zero, the aggregate value of the market should only fall by 4%-5%. Therefore, we believe the proper question to ask when analyzing the coronavirus (or any emerging macro risk) is ‘How much will this affect the long-term cash flows of businesses?’ (We) doubt very much that the owner of a thriving family business would accept a dramatically reduced offer for her entire company today versus two months ago simply because of virus fears.”
The last sentence is key. If you own a business today (and many of you do) would you sell it at a price 10% to 20% below last year’s valuation because of the coronavirus? If the answer is no, then you must ask yourself why you would liquidate your stock portfolio today?
How Will Policy Makers React
We’d be the first to claim we have no unique insights into the medical risks of the coronavirus, but one thing we can say with some certainty is that global policy makers will not sit idly by while recession risks build. They are almost certainly going to take some action. We are already seeing hints of both fiscal and monetary countermeasures to address the situation:
1) In Hong Kong all permanent residents aged 18 and above will each receive a cash handout of $1,200 in a $15 billion relief deal. In addition, the government will also slash income tax for some residents, give low-income residents of public housing a month of free rent, as well as provide a one-off allowance to 200,000 underprivileged households.
2) Even Germany might get into the game. Bloomberg reported on Thursday:
“Germany is looking at a range of measures to address economic damage from the spread of the coronavirus and protect its key export sector from a global slowdown. The government’s plans would seek to improve conditions for doing business, including reducing the tax burden on companies and boosting tax relief for digital investment.”
3) The odds of global central banks cutting rates have gone up dramatically. For example, in the U.S. the probability of the Fed cutting rates three times this year now stands at roughly 90%, as you can see below. We shouldn’t rule out a rate cut before the March 18th meeting
4) We have seen a dramatic fall in longer-term interest rates around the world. For example, the yield on the 10-year Treasury has fallen below 1.2% and is now at the lowest level in history. While not a panacea, this will help support growth in the U.S. if only through the housing/mortgage channel.
Will any of this make a difference? After all, lower rates and/or fiscal spending can’t cure a virus. However, they will help in a couple ways. First, from a sentiment standpoint, it will assure investors that central bankers will do all they can to prevent a deep prolonged global recession. At some point this matters.
Secondly, Bank Credit Analyst makes the argument that lower rates combined with fiscal support should help prevent a negative feedback loop from developing. To quote BCA:
“Monetary policy will come in handy only after the outbreak subsides. The dislocations caused by the virus could push many businesses towards the brink of bankruptcy. This could trigger a feedback loop of reduced spending, less hiring, and even lower spending. Timely stimulus would short-circuit this vicious cycle. That said, given that interest rates are already close to zero in most countries, much of the burden of preventing an extended downturn will have to fall on fiscal policy.”
These are clearly trying times for investors. The temptation to make dramatic portfolio allocation changes is about as high as it has been since the financial crisis or the European debt crisis. But we would caution against doing anything rash. We are in the ‘this too shall pass’ camp. While an emotional decision today might feel good now, we may very well come to regret it in retrospect. A few general thoughts going forward:
– It seems pretty clear more cases will start popping up in the U.S. and around the world over the next few weeks. This quite likely could lead to more pressure on equity prices over the short-term.
– The global economic data over the next two-to-three months will be miserable and earnings expectations will come down dramatically.
– However, there is a level in the stock market where this news is priced in. We will only know this in retrospect, but the selling late this week had hints of panic to it that could be a contrary indicator.
– At some point the authorities around the world will get a handle on the spread of the virus, much as they seem to have done in China. Whether this happens a week from now or three months from now is impossible to assess at this point, but the odds favor the rest of the world following China’s path. Infection rates spike, quarantines are implemented, and ultimately the virus starts to burn itself out.
– If this proves to be the case, investors will start to look through the growth slowdown/contraction over the next month or two towards a recovery. If past experience with other viral outbreaks is any guide, the eventual economic rebound could be solid.
– We do not agree with the pundits who liken today’s environment to the financial crisis of 2008/2009. During that downturn much of the banking system was essentially bankrupt and the credit system was broken. The major asset for most consumers, their home, was in freefall. This simply is not the case today. No one is talking about hitting the ATM on a Friday because their bank may not be there come Monday morning. The current situation is certainly serious, but we think the talk about global depression is too extreme.
– Diversification works. For most clients in a 60/40 type allocation, the last week has been painful, but far from disastrous. Portfolios are down roughly mid-single digits YTD after being up in the high-teens last year. Corrections never feel good, especially when they happen as quickly as this one, but bonds have done what they were meant to do during this downturn and balanced portfolios have benefited as a result.
– Time horizons matter. No one knows the future, but if your time horizon is longer than the next two-to-three quarters, it is well worth considering staying the course with a diversified balanced portfolio.
– Talk to your advisor. During stressful times it is often best to talk through the various options with another party.
Have a good weekend.
-The Team at Gemmer Asset Management LLC
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