March 3, 2020
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
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As the impact of COVID-19 (the coronavirus) continues to spread throughout the globe, investment markets have been fraught with volatility. Since the most recent peak on February 19th, the S&P 500 is down 12.3% through last Friday, and 8.3% for the year. Historically, a drop of 10% or more is considered a market correction, and the most recent occurrence is the fastest in history, occurring in only six days. There have been 27 market corrections since World War II, with an average decline of 13.7% taking an average of four months. To say this past week was unique is an understatement.
The market impact has been strongest in the U.S.; however, all equity markets have suffered. Over the same time period, international developed markets were down over 10%, and emerging markets were down over 8%. All equity markets gave back what they earned in 2020 and are now down 8-12% for the year.
Although the S&P 500 being down 8% at the beginning of March is unexpected, it is not a reason for panic. Historically, at some point during the year, the market drops 13-14% on average, despite being positive 75% of years:
While the risk of a global pandemic is the driver of the market’s decline on this occasion, there is usually something that spooks the market in any given year.
This is also not the first time the market has had to digest a viral outbreak. At the end of January, the World Health Organization (“WHO”) declared the coronavirus outbreak a “public health emergency of international concern” (PHEIC), which is the sixth declaration over the past fifteen years. As seen below, many prior epidemics and fast-moving diseases have been nonevents for global equity markets.
In the short term, markets remain volatile because of a lack of clarity regarding the potential spread of the virus and its impact on global economic growth. As has happened historically, we expect the impact of the virus will weaken as monitoring techniques, response times, and treatments steadily improve. In previous outbreaks (e.g., SARS 2002-2003), financial markets and the economic data rebounded when the number of cases reported leveled off.
However, one key difference is that at the time of the SARS outbreak, China accounted for roughly 4% of global economic output according to the IMF. Today China is 16% of global output, making it the world’s second-largest economy. While China has the most to lose from a GDP growth perspective, the potential impact to the rest of the world appears digestible:
The U.S. could see a 0.25% decline in GDP, and the world as a whole, potentially 1.0%. This would bring growth below already low levels, but still positive. Even China, with a 5% reduction in GDP, would still be mildly positive.
While the risk of a pandemic is the primary driver of the recent correction, there are potentially other factors at play. First, this comes at a time when the market was already exhibiting many late-cycle symptoms, including stretched valuations:
There is also the possibility that a Democratic nominee whose policies run counter to Wall Street is weighing on markets.
Over the weekend the ten-year treasury was as low as 1.03%, and markets are pricing in a high likelihood of a Fed rate cut in support of global markets. We would not be surprised to see this happen; however, it may be too early to determine the long-term impact of the coronavirus on the economy and, therefore, too soon for the Fed to act, especially given where rates are today.
With history reminding us that the impact of viral outbreaks is not a long-term detriment to the economy, and the high probability that the Fed will provide stimulus should conditions weaken further, we do not think the right response is to reduce risk in this market. Clients who are well diversified in fixed income and non-traditional asset classes, both liquid and illiquid, have appropriate risk mitigants in place that are doing their job. Virtually every non-equity investment in client portfolios has held its value over the last week and a half. Building portfolios that are prepared for risky events allows us to avoid panicked short-term responses. Should equity markets continue to deteriorate, we may look to rebalance into weakness, taking advantage of the stability of diversifying assets to provide capital that can be used to buy lower cost equities.
We will continue to monitor markets and portfolios as they evolve. Should clients have questions or wish to discuss further, feel free to contact a member of your engagement team.