The situation regarding the COVID-19 coronavirus1 remains fluid. Reports of new cases in northern Italy, Iran, South Korea, Japan, and Singapore likely informed the February 24 market sell-off. Meanwhile, there is evidence of a decrease in new cases in China’s Hubei province – the epicenter of the outbreak – although some skepticism about data methodology and reporting remains.
Belated Market Reaction?
Have markets been too sanguine regarding risk and the impact from COVID-19? Maybe. Maybe not. But the increase of new cases outside of China has changed the sentiment backdrop. Data from the National Association of Active Investment Managers, Investors Intelligence, and the American Association of Individual Investors as of February 21 suggests that investor sentiment remains optimistic – but far from euphoric. This leaves room for a reset of sentiment to lower levels.
Rethinking COVID-19’s Impact
While equities – particularly tech and international – continue to see inflows, markets are likely to remain on edge until there is strong evidence to suggest the virus is contained. Not surprisingly, news of the virus spreading to Europe and elsewhere in Asia has not helped assuage fears. The result? The near-term market upside could be capped – with increased downside risk as markets reconsider the global impact of the outbreak.
Prescriptions, Placebos, and Policy Responses
COVID-19 has delivered a global economic shock that is disrupting both manufacturing and services – the result of adverse impacts to supply and demand. We continue to believe that stimulus from central banks combined with supportive financial conditions will help lift the global economic backdrop. However, as confidence wanes around the virus, these factors could become less supportive. In other words, if you are worried you are going to contract a virus, you become a shut-in. Whether you can get cheaper financing to buy a house or a car really doesn’t matter.
Moreover, while looser financial conditions can help support demand issues, they do much less to support supply concerns. As cases in Europe are reported, investors should consider what policy options remain available to the European Central Bank (ECB), particularly amidst a near-recessionary backdrop in some countries. The ECB has already set interest rates below zero, while officials in Germany – Europe’s largest economy – seem content to maintain their “wait and see” approach.
One policy lever that China has pulled in the past to help stimulus growth has been through currency measures. Any weakness in the Chinese yuan (CNY) has the potential to support China’s exports as supply chains come back online post-outbreak. While we expect the yuan to be managed diligently, outright devaluation is probably unlikely. Investors should remain mindful that a weaker CNY could pressure other emerging markets in Asia to follow suit, posing a risk to the US dollar-based investors whose debt would become more expensive.
Crisis Comparisons (and the Road Ahead)
We believe that parallels between COVID-19 and the Global Financial Crisis of 2007–08 are drastically overblown. Key financial intermediaries are in much better shape now – highly capitalized, under greater scrutiny, and limited proprietary positions. Forced deleveraging was the driving force behind the massive drawdowns back then – this does not exist today. While the shift in market sentiment that we are seeing is concerning, we believe vigilance – not full-blown bearishness – is in order. As the situation unfolds, it is important not to discount the costs of COVID-19 in human terms. As laudable efforts to combat and contain the disease continue, the shortage of available assets could help stave off any significant market sell-off.
Implications for Investors
In this scenario, the phrase “The devil you know is better than the devil you don’t” certainly applies to investors. Markets do not like uncertainty, and the outcome for the coronavirus squarely falls into this category. The potential outcomes for the market’s response remain path-dependent. Most importantly, the market wants to see evidence that the spread of the virus has been contained. This would provide an increase of certainty around the global economy, helping to restore investor confidence and risk appetite.
What shape the recovery will take remains a function of uncertainty – as the duration of the uncertainty persists, the markets will move from a V to a U to a W to an L-shaped recovery. The longer the uncertainty drags on, the more the real damage to the real economy which forces asset prices to re-rate in step.
- Ground zero
China is at the heart of the outbreak and will most likely see some of the quickest and harshest repricing. Keep in mind, however, government-sponsored entities and patriotic buying – coupled with a ban on short selling – have supported domestic prices more recently. (Think China A Shares.)
- First derivative impacts
Consider the likelihood that locations that sit in proximity to China – or do a fair amount of business with China – will be adversely impacted. (Think Korea.)
- Crowded trades
Those positions that have seen many investors flocking to them of late tend to see those same investors exit just as fast. (Think tech.)
- Weak fundamentals
Consider those regions where the economic prospects have been fragile and the recent economic upswing nascent. (Think Japan and Europe.)
- Areas of relative strength
The US economy entered this volatility in a much stronger position than many other developed regions. A strong consumer, buoyed by a strong labor market and rising wages, underpins the US growth story. This starting point provides a cushion which could help absorb economic uncertainty.
- Monetary policy response
The US Fed still has the capacity to cut interest rates to help offset any economic weakness. Many emerging economies also have room to ease, given that most emerging economies still hold higher real rates that can be lowered to stimulate growth.
- Fiscal policy response
Several emerging market governments have indicated plans to increase fiscal expenditures as a means to jumpstart growth.
Thinking About Risk
In times of elevated uncertainty and increased volatility, risk management becomes imperative. We entered the start of the year with an optimistic outlook on the US and global economy and the continued recovery. This outlook has certainly been delayed. Whether or not it becomes derailed is now the more important issue. Given these developments, reining in risk certainly seems appropriate. Until a clearer outcome emerges, we prefer to play things close to the vest. To reflect this thinking, we have reduced our equity exposure and increased our safe haven assets to reflect this backdrop.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.