Equities sold off today (-3.3%) on rising concerns over the spread of the coronavirus given a spike in the number of new cases reported in Italy, S. Korea, Iran and Iraq. Despite these reports the World Health Organization noted they are not witnessing the uncontained global spread of this coronavirus (historically referred to as a pandemic). Additionally, these industrial economies (Italy and S. Korea) have robust public health infrastructure and the ability to manage even large outbreaks. But, the market correction is understandable given the economic costs associated with containment and the fact rapid case growth is occurring in countries like Iran and Iraq where the public health and general health care infrastructure are not as robust. China has shown COVID-19 can be contained, as the rate of new infections has been down 5 out of the last 6 days.
Economists are still not predicting a global recession
The outcome of Covid-19 is still uncertain in terms of severity, global scope, and longevity as we haven’t yet confirmed a peak in the rate of infection. The outbreak does have the potential to cause severe economic and market dislocation but we emphasize the uncertainty in any forward estimates as the scale of the impact will ultimately be determined by how the virus spreads and evolves, which epidemiologists currently state is almost impossible to predict. Currently, we are seeing downward revisions in 2020 global GDP expectations, but at this point even conservative expectations are still positive (Global GDP estimates now 2.75% vs. 3.4% to start the year). We acknowledge that there is downside risk to these growth expectations as the coming weeks will be very crucial for determining how successful the world has been at containing the virus. The good news is that the lagged effects of the global easing cycle, coupled with lower long rates, were already helping boost global growth. Once the outbreak abates, there is some probability of experiencing a global V-shaped recovery (a sharp decline followed by a sharp rise back to the previous peak). At this point we have not materially changed our outlook for subdued but positive economic growth as we favor expectations that the economic and market disruption will prove temporary.
Market reaction is suggesting investors don’t expect a global pandemic
More near term panic will weigh on risk, but panic is necessary to increase containment odds and policymakers around the world are already applying both monetary and fiscal stimulus. The VIX curve (measure of volatility), is reflecting a sharp increase in near term volatility, but little change in longer term volatility, suggesting investors anticipate a temporary disruption. Credit spreads have reacted in tandem with equity. After having a relatively quiet Thursday and Friday, moving out 1bp each day, CDS for investment grade bonds widened 6.5bp to 53bp today. This is the largest move since September, but still below the 2019 average.
At market close on February 24th, year-to-date global stocks are down -1.6% while the Bloomberg Barclays Aggregate bond index is up 2.9%. Real assets are still producing positive YTD returns – with REITs up 5.2% and Infrastructure up 1.6%. Diversification matters!
Accounting for exogenous shocks in the strategic planning process
An assessment of economic and corporate fundamentals and current market valuations allows us to formulate reasonable near term expectations, but there is always some probability of an exogenous shock derailing this assessment. By definition an exogenous shock cannot be foreseen, it is unexpected or unpredictable. We did not factor in the risk of a virus outbreak in our 2020 outlook, but we account for the possibility of such an exogenous shock during the portfolio construction and strategic planning process. For example, our team quantifies the range of annual returns we can expect for any given strategy. For example, we expect a balanced portfolio (55% stocks / 45% bonds), to experience a range of annual portfolio returns from -11.9% to 24.0% to arrive at the long term average of 6.0%. But, it’s essential to bear in mind that even if we know the probabilities, that doesn’t mean we know what’s going to happen and when. This reality is formulated into our investment management process by modeling thousands of different return paths to confirm the viability of our client’s long term plan despite market volatility that every investor will inevitably experience.
Current portfolio positioning
Within a long time horizon, one way to optimize the positioning of a portfolio at any given point in time is through deciding how aggressive or defensive one should be relative to their long term strategic allocation. Given the uncertainty surrounding the ultimate impacts of the virus and the chances the current disruption proves temporary, we continue to recommend maintaining a neutral allocation. Additionally, we maintain an up in quality stance within U.S. large cap equities and actively managed fixed income portfolios.
Brandy Niclai, CFA®
CIO, Multi-Asset Strategies