The Wall Street adage, "stocks take the escalator up and an elevator down," pertains to the market tendency to rally along a shallower glide path than it does when some unwelcome news hits the tape and it typically turns into a swift selloff.
The coronavirus is that news. Of course, arguably the stock market’s price-to-earnings ratio, which recently hit 19.0 times estimates for 2020 S&P 500 company earnings, was just rich enough that any less-than-good news could have catalyzed the
selloff. Indeed, if it wasn’t a threat from a contagious and lethal virus, it likely would have been something else.
Regardless, the coronavirus is a serious concern and markets are trying to handicap its still fluid evolution. The risk of a pandemic is something we would categorize as a black swan, defined as a low-probability, but high-impact, event. Its breakout just weeks ago served to crystallize the loitering probably of a sudden shift in sentiment. We are of the belief that global economic conditions are sound enough that any relatively brief slowdown this causes should recover quickly. History suggests as much. Still, until such time that the number of cases reported with the virus decelerates, it is impossible to know the ultimate impact.
Past Epidemics Provide Some Insight
We can consider this the ninth major epidemic that has broken out during the past 20 years or so. The countries of origin for the epidemics vary, but
severe acute respiratory syndrome (SARS) in 2003, and now the coronavirus, began in China. This is important economically because of the sheer size of its economy.
In 2003, China represented less than 5% of global gross domestic product (GDP), while today it is just over 19%. In addition to its absolute size, its growth rate makes China’s economic activity responsible for about 33% of the world’s annual growth impulse. By way of comparison, it dwarfs the U.S. impact at 10%.
Today, China consumes double-digit percentages, and in some cases more than half of the world’s production of industrial metals, oil, semiconductors, computers, and cars. This is many times what it purchased annually back in 2003. In addition, China has made a deliberate and fairly successful pivot to having consumption be the primary engine to growth, rather than relying on fixed investment like it had back in the 1990s and 2000s.
Therefore, it makes looking at history as a guide for the economic and financial market consequences coming from the coronavirus, when compared to SARS, MERS (Middle East Respiratory Syndrome), Zika, Ebola, or the Swine and Avian flu viruses emanating from regions that were vastly smaller than China is today, somewhat dubious. Having said that, while the number of cases reported with the coronavirus now exceeds that of SARS, the percentage of those who have died as a result is just over 2% so far, markedly less than the 10% associated with SARS or the 33% with MERS.
What we can observe, however, is a clear pattern in global equities in response to the outbreak of these contagions. In most cases, global stocks tend to decline when the outbreak occurs. The declines are swift, but generally not very large and tend not to last terribly long likely because the outbreaks are contained in a relatively short time. No outbreak in the past has even caused a major global equity correction. Historically, stocks tend to respond to other major macro events that are taking place at the time that obscure the effect of epidemics.
Clearly, there is a lot of deserved concern about the coronavirus outbreak evidenced
in the stock market as prices have declined, consistent with a flight-to-quality dynamic. In the bond market, the yield curve has inverted between 10-year and 3-month Treasury bond maturities, which has historically been a harbinger of a slowdown
in growth ahead. However, the curve has inverted because the term premium has fallen (the term premium is considered to be compensation for all the uncertainties, including inflation, over the life of a Treasury security), because investors are fleeing
to the safety of Treasuries. Interestingly, this is occurring while expectations for growth in the U.S. are actually picking up a bit, after having declined for many months. Therefore, the inversion of the yield curve, in our opinion, represents fear
rather than an expectation of recession that is likely to ensue.
The situation remains fluid, but we recommend staying the course because in the absence of a recession, markets will recover and possibly abruptly. Remember, markets will not need to see the coronavirus outbreak end in order to regain footing, rather the deceleration of reported cases and less lethal outcomes accompanying it, will be enough to have markets respond favorably.
In order to avert getting whipsawed by lurching into a defensive posture only to see things turn for the better more quickly than might have been anticipated for any reason, we advocate staying committed to global equities but as always, in proper proportion to one’s risk budget.
Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment.
This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis.