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Special Market Update: Our Perspective on the Coronavirus and Market Volatility

Special Market Update: Our Perspective on the Coronavirus and Market Volatility

On March 2, Managing Director Kaan Eroz and a panel of experts met to discuss the latest developments and our recommended portfolio positioning

 

Special Market Update Call – Coronavirus
 

On March 2, Managing Director Kaan Eroz and a panel of experts met to discuss the latest developments and our recommended portfolio positioning given what is currently known. 

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Special Market Update

February 26, 2020

— After a severe global sell-off during the first two days of the week, U.S. equities are attempting to find some support
— As of market close on Wednesday, the S&P 500 is down over 8% since its most recent high
— Meanwhile, global bond yields have fallen in a flight to quality
— Our base-case scenario continues to be that the virus-related hit to economic growth will likely be short-lived, with an eventual bounce back in the second half of the year
— History suggests that both economies and markets eventually rebound following epidemics
— Although volatility may persist, investors should remain focused on their long-term investment strategy

IMPACT ON MARKETS AND ECONOMIC GROWTH

Concern over the spread of the coronavirus and the impact it could have on global growth sent global equities lower, with indexes down 4-7% on a total return basis over a two-day period.

On Wednesday, U.S. equities attempted to regain their footing in a volatile session and finished mixed. The S&P 500 is down nearly 6.6% for the week and over 8% from its recent high on February 19.

As expected, global bond yields have declined as investors seek safe-haven investments. On Wednesday, the yield on the U.S. 10-year closed at 1.31%, its lowest level ever.

The three-month to 10-year part of the Treasury yield curve inverted, suggesting that the market is telling the Federal Reserve to reduce rates.

In fact, today, the market is discounting two Fed rate reductions this year and one more next year. However, a timing mismatch between market expectations and Fed action may result in periods of volatility.

The coronavirus is showing signs of spreading more rapidly outside of China, with a spike in cases in South Korea, Italy, Iran and new cases in South America. As of February 26, the virus has infected a total of 80,000 worldwide and has killed over 2,700. Governments are racing to control the contagion by limiting travel and quarantining patients.

We continue to believe that the virus will eventually be contained, however. While difficult to estimate, we expect that this virus may take 0.5% to 1.0% off of global GDP in the short run, with U.S. GDP reduced by 0.1% to 0.2%. From an economic perspective, we are clearly seeing supply-side disruptions as fewer working hours result in lower output. Demand will be impacted too, particularly for services.

These estimates may prove to be a bit too conservative, however, as the aggressive steps China and other countries have taken to combat the spread of the virus may put even more downward pressure on growth.

WHAT HISTORY TELLS US

With equity valuations slightly stretched and investor sentiment still at modestly elevated levels, stocks were vulnerable to a correction. We do not believe this is the beginning of a longer-term pullback or bear market, however, as periods of economic expansions typically end as a result of recessions or credit crunches.

As Exhibit 1 shows, the S&P 500 is generally higher in the months after a virus first appears. The coronavirus has been compared to the SARS outbreak, which had a mortality rate of 8% — much higher than the estimated 2% from this virus.

So while the ride has been bumpy as of late, history indicates both economies and equity markets eventually rebound as these epidemics subside.

Economies typically experience weakness in the near term as supply chains get disrupted, with growth eventually snapping back as they regain full capacity.

 

WHAT WE'RE WATCHING

There remains great uncertainty about the severity and longevity of this virus and its downstream impact on global growth and earnings. Consequently, we continue to monitor key factors that will shape our outlook and portfolio positioning.

U.S. consumer confidence. U.S consumers account for 70% of U.S. economic activity. We will watch for any deterioration in confidence that could negatively impact spending.

Credit spreads. A severe widening of credit spreads typically indicates elevated levels of fear, but so far spreads remain relatively orderly. Not surprisingly, we have seen some pressure in high yield bonds, with spreads 80 basis points wider year to date, but still within a comfortable range.

Central bank response. China's central bank has responded with several policy actions that should help to support growth, but with a lag. Additional support by global policy makers would help to mitigate the impact of the virus on global growth.

Vaccines and treatment options. Many companies, such as Gilled Sciences and Moderna, are developing vaccines and treatment options. As we see better treatment options and potentially lower mortality rates, this should help to alleviate concern about a more widespread outbreak.

Our investment strategy committee, which is responsible for making portfolio positioning recommendations, met today to discuss and assess the recent uptick in market volatility, the latest virus statistics and leading economic data points. We are not surprised to see some companies adjust their short-term outlook and earnings guidance given that the virus has affected supply chains.

The committee continues to believe that the impact to economic and earnings growth will be modest and short lived, with an expected rebound in the second half of the year. As history has shown us, exogenous events such as epidemics often present better entry points than exits and thus, investors should stay focused on their well thought-out investment plans and long-term goals. For now, we believe a well-diversified investment portfolio with a neutral weight to equities, and a tilt to the U.S is still the best positioning at this time.

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