It was December 31, 2019 when the World Health Organization’s China office heard the first reports of coronavirus, which is now called COVID-19. From a tracking and measuring perspective as it pertains to the markets, we can reference year-to-date numbers as a gauge on the effects.
The market’s reaction and anticipation to the future implications of the virus has been mixed (Figure 1). In fact, the market was reasonably strong up until the last week when the brunt of the sell-off occurred. The sell-off in the markets intensified over the previous week as the virus has spread outside of China, and investors began to price in much weaker expectations for economic and earnings growth. Now even the “recession” word is being factored in.
Figure 1: Year-To-Date Performance
*As of February 28, 2020
From our perspective, there are three main reasons for this most recent decline.
1. Fear of the unknown
As the virus spreads outside of China, the awareness and unknown possibilities take on greater importance. Stock markets hate uncertainty, and this is having adverse effects in the market as investors react and sell stocks. Investor sentiment has turned remarkably bearish as stocks are becoming oversold; however, not quite at the extremes reached in December of 2015 and 2018 (Figure 2).
Peter Lynch, the legendary investor from Fidelity, has an appropriate quote for these times: “The real key to making money in stocks is not to get scared out of them.”
Figure 2: Panic/Euphoria Indicator
Source: Scotiabank GBM Portfolio Strategy, Bloomberg, Baker/Bloom/Davis
2. Concerns of a global recession
We believe a portion of this recent market correction is rational. The economic reality from the virus is undoubtedly slower and weaker growth in most major economies, and what is primarily causing investor anxiety is how long this impact may last. In our view, it is too early to make any accurate assessments on whether this virus will cause a global recession. However, stock markets are already pricing in a significant slowdown in global growth.
Historically, most virus-impacted economic slowdowns have been transitory and took on a V-pattern: a sharp slowdown followed by a sharp rebound, based on pent-up demand and easing by central banks around the world. Over the last two weeks, bond yields and interest rates have been plunging, which is providing significant stimulus to the global economy. An important policy dynamic we are watching in the coming weeks is how central banks around the world react to the impact of the virus, and if they will consider coordinated global interest rate cuts. This would be bullish for the economy and stocks.
As referenced earlier, bond yields have collapsed and the current 10-year US Government bond yield is at 1.15%, the lowest yield ever. It is normal for bond yields to fall when investors are fearful and concerned about global growth. We feel the bond market is already pricing in a recession with interest rates at extreme lows. In addition, lower bond yields will buffer the economic impact of the virus and help reduce borrowing costs for consumers and businesses around the world.
Figure 3: US 10-Year Government Bond Yield
3. Computer trading and forced liquidation within Index and ETF Funds
A third force in the markets is that of a technical nature, which is selling from systematic strategies and computer trading like algo-trading. Back in January 2019, we wrote a blog titled “The Rise of The Machines”, where we discussed how computer trading makes up close to 60% of all equity trading in the US and how this has a significant impact on market volatility.
Globally, a large portion of capital is traded based on computer-generated algorithms. When certain patterns emerge (or certain downsides are reached), these programs simply sell stocks indiscriminately, creating enhanced volatility among stocks especially when fear is prevalent.
Computer trading is here to stay, and it is a reality that we, as fundamental bottom-up investors, have to deal with. What is most important is taking advantage of buying high quality companies at discounted prices when such selling occurs.
The reported new cases of the virus in Hubei and the rest of China have been declining, which could be a sign that the epidemic in China is abating. In addition, Chinese authorities have been aggressive on the stimulus front, implementing new fiscal and monetary policies to help offset the negative economic impacts of the virus. We will be closely watching economic data coming out of China in the near-term, expecting to see significant short-term weakness. Again, we feel stock markets have already priced in most of the economic weakness expected in China.
Unfortunately, the virus has been confirmed in a growing number of countries outside of China with over 2,400 cases reported so far (Figure 4). This is one of the main reasons for last week’s sell-off as investors now price in the virus spreading more globally. At this point, it is highly uncertain how much more the virus will spread outside of China. Stock markets will be sensitive to this trend, both on the upside and downside. It will be important to watch the trend in new cases outside of China. If this trend stabilizes, the market reaction to the upside could be quite significant.
Figure 4: COVID-19 confirmed cases (World excluding China)
*As of February 25th, 2020
Source: World Health Organization; CEIC; Johns Hopkins CSSE
We have been taking advantage of the volatility by adding to a number of our positions last week. One of the criteria of our investment process is balance sheet quality, which means that we invest in companies with low levels of debt. When there is an economic slowdown or recession, balance sheet strength is one of the most important factors for stock outperformance. Companies with strong balance sheets give us confidence that even if revenue and cash flows are impacted on a short-term basis, the business will be able to weather a tough economy and continue to thrive.
More specifically, we have taken the ‘barbell approach’ within our portfolios by adding to select businesses within two groups of companies. First, we identified a group of quality businesses that will be impacted by the virus. These types of businesses might be slightly more cyclical in nature. Even though we expect a short-term hit to revenues and cash flow, the company valuations have hit extreme levels that the risk/reward is attractive over a three-year investment horizon. Examples are Air Canada, Renault (French auto), and Rio Tinto (UK mining).
The second group would be what we call high quality growth companies. Examples are Microsoft, Visa, and Johnson & Johnson. Companies in this group have generally been quite expensive for the last 6-8 months. However, we are incrementally adding to select names and will become more aggressive buyers if prices get cheaper.
We have also added to our Fixed Income portfolio in the floating rate corporate bond sector. We have uncovered opportunities in select floating rate bonds with a minimum floor of 4%. We’re sitting tight within the government bond market. These bonds have become expensive and yields have been collapsing as investors bid up bond prices. We feel cash instruments earning 1.50-2% make a better investment for fixed income vs. locking up your capital for 10 years at 1.15% in a government bond.
Since 1979, US stocks have had positive annual returns 75% of the time. Stocks fall on average by 14% every year, measured from peak to trough. A correction once a year in the range of 10-14% is normal. In times of uncertainty, and particularly in times of market weakness, it is important to be reminded of what is in our control and what is not.
What we can control is building a diversified investment portfolio that is suited to each of our client’s needs and risk tolerance. Our Client Portfolio Management team is here to provide value, counsel, and guidance by developing a long-term investment strategy and helping you adhere to that plan.
Another factor in our control is the specific investments we hold inside our clients’ portfolios. Adhering to a disciplined research process helps us ensure we are invested properly in sectors and companies where we see the best risk/reward trade-off.
We believe COVID-19 is a transitory event for the global economy. While the full extent of the economic consequences is highly uncertain, global central banks stand ready to cut interest rates and provide stimulus through other monetary measures where and when needed. With market corrections being a normal annual event, we will continue to utilize our investment process to navigate the equity and fixed income markets to our clients’ advantage.
If you have any questions or comments, reach out to our team by filling out the form below.