As concerns mount against the spread of the Coronavirus (COVID-19) to the United States, we have many clients getting in touch with questions and concerns surrounding the recent market activity. In light of this, we wanted to compile some further information for sharing with you.
What is COVID-19?
According to CDC.gov, “Coronaviruses are a large family of viruses that are common in many different species of animals, including camels, cattle, cats, and bats. Rarely, animal coronaviruses can infect people and then spread between people such as with MERS-CoV, SARS-CoV, and now with this new virus (named SARS-CoV-2).”
Referred to as the Wuhan coronavirus for the Chinese city where it is thought to have originated, the respiratory illness has already taken a harsh toll in China. More than 1,000 people have died and thousands of cases have been confirmed, according to multiple news reports, although the majority of cases remain unreported.
While some cases have been reported in the United States, the U.S. government is the global leader in infectious disease response. Through the Strategic National Stockpile, the United States has millions of masks and other critical items to mount a response, if needed.
Travel restrictions and quarantines are in place for parts of China, and much of the disruption caused by the Wuhan coronavirus has occurred in areas of the market related to travel. That includes airlines – China is offering to refund domestic flights and train tickets nationwide – casinos, cruise companies, and retail.
While the primary concern is for the people whose lives are affected by this virus and containing its spread, the effects of the accompanying market drop may feel troubling as well. The drop represents the first notable pullback for major domestic equity indices this year.
At times like these, it’s important to remember that, historically, epidemics have led to increased short-term volatility – the avian flu in 1997, SARS in 2003, swine flu in 2009 and Ebola in 2014, for example – but done little to derail the long-term outlook for the market.
The market impact continues to display three dynamics in the midst of the coronavirus outbreak: a flight to quality, bias toward defensives over cyclical, and a heightened negative impact based on proximity to the most impacted regions.
Flight to Quality
Since the outbreak, we’ve seen a rally in Treasuries, gold, and the dollar. Overall, these less risky assets have seen strong inflows and strong outperformance. Longer duration bond yields have fallen sharply year-to-date (YTD) and are now nearing the lowest level (10-year Treasury yield: 1.38%) on record. This is consistent with the price action in gold, which is up 5.7% since the start of the year and is currently trading at the highest level since early 2013. Additionally, since the US economy has remained fairly contained from the virus thus far, the US dollar is up 3% YTD and is near the highest level in two years.
Defensives Over Cyclicals
With growth concerns seeping into the market and interest rates continuing to fall, cyclical sectors have seen the worst performance while defensive sectors have outperformed. Utilities and real estate have been the two best performing sectors since the initial coronavirus outbreak, while those most exposed to both global and Chinese demand (e.g., energy and materials) have been the worst-performing.
The countries with substantial upticks in cases with close proximity to China (e.g., Japan, South Korea), and those with more exposure to China’s economy (Europe in general) have been amongst the hardest hit.
Unforeseen, immeasurable, and intensifying risk factors such as pandemics lead to market volatility. The truth is that no one really knows the impact the coronavirus will have. The financial markets had been complacent, hoping for a quick “V” shaped recovery following the initial decline, similar to that of previous viral outbreaks. UnforBut the ‘game-changer’ over recent days has been the spread of the virus to other countries (e.g., Italy, South Korea, Japan) that are more transparent about the effects and this will likely reveal some ‘truths’ about the dynamics of the virus (e.g., how contagious, death rate, incubation period, recovery period, etc.). Thus far, while the number of cases outside of China has moved sharply higher over the past few days, the mortality rate remains muted relative to previous viral outbreaks.
The US economy is not the US equity market
US economic fundamentals remain strong and echo our sentiment of a muted risk of recession over the next 12 months. The US economy may be able to avoid the worst of the virus given that exports make up only 5% of GDP, but keep in mind that ~40% of S&P 500 revenues come from overseas. With an increasing number of downward revisions to growth in Asia (especially China) and in Europe (Italy will likely enter recession) future US earnings expectations will be closely monitored. Further, increasing supply disruptions due to shutdowns in China could be a detriment to revenues, costs, and margins.
The equity market is a forward-looking barometer
The equity market tends to lead the economy by approximately six months, so if the market expects a solid rebound in economic activity in Q3, the expectation should filter through to the equity market over the upcoming months. It is important to remember that manufacturing indicators prior to the coronavirus outbreak had been signaling a turnaround once trade induced weakness and uncertainty had been placated by the phase one trade deal.
Lower (negative globally) interest rates make equities more attractive
With ~$13.7 trillion in negative-yielding debt globally and with the US 10-year Treasury yield at record lows, equities look particularly attractive relative to bonds as the S&P 500 dividend yield outpaces that of most other global developed market sovereign bond yields. Additionally, since the market is now pricing in at least one additional Fed rate cut and further easing from other global banks, looser monetary policy should further ease global financial conditions and support risk assets.
One risk to monitor going forward is the recent strength of the dollar. While the dollar remains in a nearly ten-year upcycle, moderation in dollar strength had been less of a headwind in 2018 and 2019 relative to previous years. However, with the coronavirus leading the dollar to rise to multi-year highs, this will likely weigh on the earnings of multi-national earnings as a stronger USD historically has posed a headwind for those companies with greater global exposure.
It is our belief that, while volatility is likely to continue to weigh on these sectors in the near term until the virus is contained, overall, we remain constructive in our 2020 outlook. Moreover, some consolidation in the near term may present opportunities to accumulate favored sectors.
We hope you found this overview informative, and as always we will be sure to continue to monitor data as it comes in and share any new critical developments with you.
As always, please reach out to us with any questions you may have. Thank you for your trust in us.