MCF Weekly Capital Market Review - March 2nd, 2020

There are over 89,200 confirmed cases of Covid-19 with 3,048 confirmed deaths. Over 2,800 of these deaths are in China.[1] A positive within these figures is that more than half of confirmed cases already have recovered. It’s difficult to estimate figures such as the mortality rate given the average time from first symptoms to death (or recovery) of 14 days and the lack of transparency from Chinese authorities. Preliminary estimates from the WHO and the Lancet have placed the mortality rate around 2% - 3%, although this should be interpreted with caution.[2] It’s no secret that the economic effect of the Covid-19 outbreak on markets is a giant question mark. The situation is exacerbated by the constant inundation from media outlets often focused more on headlines than clarity surrounding information.

Quantitatively measured things are clearer. The S&P 500 topped out at 3,393.52 on February 19^th and closed at 2,954.22 on the 28^th, a drop of 12.95% in a week and a half.[3] Volatility as measured by the VIX (CBOE Volatility Index) hit 49.48 on Friday, a spike in uncertainty reminiscent of 2009 levels.[4] Even the larger S&P 500 drop of 20% in December 2018 occurred with lower volatility. Looking at other measures for the same period, investors seeking safety pushed the 10-year Treasury yield down from 1.56% to 1.13%,[5] its lowest yield in history.[6] Credit spreads had a small jump[7] but nothing yet to suggest a panic in the bond markets of a deep, secular downturn. Gold, another traditional measure of uncertainty, was mostly flat.[8] 

Fed chair Powell released a statement Friday that the coronavirus is being closely monitored and reiterated the Fed will use its tools to act as appropriate.[9] Market expectations are now shifting to four rate cuts for 2020 (or 1% total) with an equivalent of two cuts for the March 18^th meeting.[10] The Fed faces a tough predicament – it already cut three times last year and four cuts this year would put rates in the 0.50% – 0.75% range. This leaves very little room to maneuver when the US is confronted with an actual recession. The Fed could delve into negative interest rate territory, a once-entertained scenario that has become the accepted modus operandi for the likes of Europe and Japan. The Fed has not ruled this out as a possibility.

If we asked the average investor what’s negatively affecting markets this year, we’d have a consensus opinion of Covid-19, and rightfully so. If we had asked what positively affected markets in 2019, we’d receive a different answer from each person asked. This example illustrates a couple points to remember for investors. First, the downsides tend to be driven more by single adverse events; the upsides tend to require a wide range of positive data to drive equity returns. Second, the downsides tend to be sharp movements; the upsides tend to notch gains slowly and incrementally over time. As investors, it’s rare to see such widespread and sensationalist news coverage on positive events as we do with negative events. The technical definition of this phenomenon is headline risk, that is, an adverse news story dominating the impetus of market returns.

It’s important to understand where we’ve been in order to see where we could be going. The S&P 500 is fresh off a 31% gain for 2019. This is well above the 10% average annual return for this index. This does not guarantee a sequential pullback, but we do know pullbacks can occur at any point. After all, there must be figures below the average 10% that balance out the knockout years like 2019. Expanding our time horizon, we also know that we’re approaching the 11^th year of an economic expansion, the longest recorded expansion in American history. As investors, we should be aware that markets do not grow in a straight line. Inevitably, there will be events that set us back, but we should not ignore the wide array of other data that contributed to our economic expansion in the first place.

Make no mistake, the Covid-19 outbreak is an adverse event that is disrupting global economic growth. Furloughed and quarantined workers, especially in China, aren’t working. No work, no product, no growth. This not only affects China’s growth but also companies and countries relying heavily on trade (both supply and demand) from China. The US comes to mind with several global companies having supply chains and significant consumer bases in places like China. The question, then, is a matter of magnitude. As investors, we ask how reflective is the recent equity drawdown of actual economic impact? Furthermore, is this event an episodic setback or is it something that precipitates a recession (two consecutive quarters of negative real GDP growth)?

We won’t have certainty for these questions until after the fact. However, we know adverse events will occur, and we must prepare for the negative effects through financial planning and well-diversified portfolios. 

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