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In the News

The Potential Impact of the Coronavirus

By:

Jon Rugg, CFA

Source: AbsolutVision / Unsplash

Anyone viewing recent news headlines has likely seen the negative market performance and fear surrounding the coronavirus outbreak.  The market performance the past few days are the most volatile we've seen in the several years.  In the post below, we share our views on the situation as well as some of the factors at play.  Much of the commentary below is adapted from a letter we sent to our Charlesworth & Rugg clients earlier this week regarding some steps we took with the goal of insulating part of their portfolios. 

It is a good reminder to us all that during volatile market periods it is more important than ever to remain disciplined and follow a strategic investment plan with an advisor acting as a fiduciary in your best interests.

A Look Back at 2019

For the past several months, we believed  it was time for caution in an investor’s asset allocation given market valuations near all-time highs and the appearance of possible cracks in the macroeconomic landscape.  To support that view, we made a partial defensive maneuver late last summer into short term US Treasuries for our clients, taking a little risk off the table while locking in some gains from the strong market performance of the first half of 2019.  

The Macroeconomic Landscape Today

In our opinion, relatively high stock valuations spurred by an accommodative Federal Reserve, general investor complacency, and deteriorating profits provide the backdrop for a potentially fragile market.  Often though, it isn’t the obvious markers that trigger a market selloff but rather something quite unexpected.  In the last few days, the market volatility and the selloffs we have witnessed appear to indicate the fear of a global pandemic caused by the novel coronavirus (COVID-19).  Below we address recent market volatility as well as our thoughts regarding general portfolio positioning leading up, and in response, to recent market sentiment.  

Enter the Coronavirus

While news of the virus first broke in January, it took several weeks before more troubling stories began coming to light that painted a more dire picture of what was happening in Wuhan, China.  In recent weeks, it wasn’t the mainstream media, but rather speaking to people in our networks who have business or family ties to China that had us paying close attention to the coverage coming out of China.  The last few weeks have witnessed stories of higher infection rates than reported, the beginnings of supply chain disruptions, and risks of a more lasting impact to 2020 GDP.  Surprisingly, most markets appeared to downplay the potential implications of the coronavirus—raising the question of whether we were missing something in our analysis.  That all changed with Apple’s announcement of an expected revenue miss last week.  This significant data point combined with our mounting concerns resulted in a reassessment and initial defensive repositioning for many of our Charlesworth & Rugg, Inc. clients last week. 

The news over the weekend of the virus spreading to South Korea, Italy, and Iran led to a dramatic market selloff on Monday and Tuesday, with the CDC announcing a likelihood that the coronavirus outbreak becomes a global pandemic.  The selloff continued Wednesday and took a sharp move down as of this post.  In anticipation of continued volatility, we assessed  taking further defensive maneuvers for our private clients this week.  We believe the risks to the downside outweigh the rewards to the upside in the current market environment as the spread of the coronavirus appears to have fundamentally changed projected economic activity in 2020.  We have previously written in our client newsletters that we will give up a little upside to protect our clients’ capital from outsized downside risks—and this is a time when, in our judgment, that is prudent.  

Past Market Performance During Outbreaks

To share a bit of historical context regarding recent outbreaks and market performance, during the SARS virus in China in 2003 the S&P 500 fell a total of 12.8% during a 38-day trading period at the height of the outbreak.  The Zika outbreak between 2015 and early 2016 saw a 12.9% drawdown in the S&P 500. Historically, as these outbreaks waned the markets fully recovered, but can an investor rely on the past, and is it different this time around?  The main adage in investing, namely, ‘past performance is no guarantee of future results’, strongly comes to mind here.  There appear to be a number of factors at play with global markets and the Coronavirus this time around. 

Our thoughts on how the Coronavirus’s impact is affecting various aspects of the markets are as follows:

  1. First and foremost, the virus concerns us and poses a risk to communities around the globe.  If it becomes a pandemic it has the potential (in one of the worst-case scenarios) to claim hundreds of thousands to millions of lives like the Spanish Flu of 1918. Currently, the mortality rate appears to be between 2-3%, with elderly populations significantly more at risk.
  2. But, the virus itself isn’t the only concern an investor should consider.  Rather, it is the uncertainty that the virus creates to the global supply chain, inventories, and businesses that most concerns us as investment advisors.  The virus appears to have put China at an economic standstill, the effects of which will bleed into the rest of the global economy in the coming weeks and months.
  3. Global supply chains are extremely interconnected.  That is why the recent US-China Trade War has been so disruptive.  China operating at 50-60% capacity as a result of the virus is creating ripples throughout businesses around the globe.  Over 95% of the Russell 1000 growth companies (some of the largest companies in the US) have a Tier 2* supply chain dependency on China—meaning the companies the Russell 1000 use to create their own products have parts that originate in China.  What knock-on effects the China shutdown will have is yet to be understood or quantified—especially if the shutdown continues for a longer period of time.
  4. Inventories are at risk of running low.  If a business has been running on thin inventory, they are at serious risk of being unable to operate or produce their end products if China, or other global trade partners, experience substantial and sustained disruptions.
  5. Compounding these possible risks comes from the significant debt load of many businesses.  If a business is highly leveraged at a time when there are inventory shortages and, as a result, reduced revenue, it is a recipe for trouble.  Lack of inventory, and an ensuing lack of sales, combined with higher levels of required debt payments is how companies can go into default and negatively affect the bond markets.
  6. The virus also has the potential to impact consumer habits.  Imagine how many people will want to take a flight or go to a concert, sporting event, vacation, or even a restaurant or bar if the coronavirus affects the daily lives of US citizens—which the CDC believes likely.  The US economy is a services—driven economy, if people consume less and demand falls, it could have a serious impact on US businesses and markets.
We believe the limited potential upside, when compared to the potential downside risks, warrants investors to review their asset allocation and assess for themselves if a more defensive position might be necessary.  

We hope our note on recent market actions provides some context to the current climate. As always, please feel welcome to contact us if you have any questions.

Disclaimer: The views contained herein are the opinion of employees at Charlesworth & Rugg, Inc., and do not constitute investment advice or financial advice. Any information shared is for educational purposes only. An investor should consult their investment advisor or financial professional before making any investment decision. Investment decisions involve potential risks of financial loss as well as potential tax implications and should be considered carefully and in line with an investor’s risk tolerance and established investment plan. 

*Source: Investment Strategy Group, FactSet, Goldman Sachs Investment Research, Dun & Bradstreet