Mid-quarter Commentary | February 2020
The Impact of the Coronavirus
The Coronavirus leads most news headlines with increased numbers falling ill and the effects spreading across the globe. How will this latest pandemic affect the financial markets? Partners Kate Campbell King, CFP® and Brian Kozel, CFP® sat down to discuss the current state of the financial markets and how a sudden and unexpected risk is reflected in our investment strategies.
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The Impact of the Coronavirus
Transcript | Recorded on Monday, February 23, 2020
Hello and welcome to North Berkeley Wealth Management’s mid-quarter commentary.
I’m Kate Campbell King and I’m here with Brian Kozel to talk a little bit about where markets are at and what we’re seeing that might come next the topic of the day is coronavirus and the way it’s spread around the world and what’s happening to control it.
But before we get into talking a little bit about that, why don’t we summarize where markets have been recently, including last year and the kind of risks we often see in the market and in the economy. Brian, can you give us a summary.
Thanks Kate. Indeed there are concerns right now about the Coronavirus and the spread of that disease as well as market impacts. But, as you mentioned, before we dive into that topic, let’s talk about where we are and what happened in 2019 as it just recently concluded. The market is coming off of a decade of fairly strong and consistent returns since the 2008-2009 financial crisis and 2019 was no different wrapping up that decade. We saw the S&P 500 up over 31%; international stocks as measured by the EAFE index up over 22%; and bonds returning a healthy 8.7% on the year as measured by the Barclay’s Aggregate Bond Index. A lot of this growth in 2019 was fueled by interest rate cuts by the Fed here in the US as well as central banks around the world. At the end of 2018, there was concern about rising interest rates. That abruptly shifted course at the end of 2018 and throughout 2019 we actually saw three interest rate cuts further fueling the appetite for risk-taking among investors and driving up the price of stocks both here in the US and globally. That is the backdrop that ran its course through the end of 2019 and found us at the beginning of 2020 with a bit of stability actually in the market before this new risk was introduced.
The risk that we’re going to be talking about more today, is that risk of a global pandemic namely coronavirus or COVID-19 as it’s been more scientifically named here, that originated in China specifically and the Chinese province of Hebei and the capital city of Wuhan and has spread throughout the world in smaller pockets sparking concern by investors right now.
As we track the market for client portfolios, we’re looking at a variety of kinds of risks. Some of it can be tracked more incrementally – seen and measured along the way. Things like rising debt levels rising inflation the trends in corporate earnings. Are they increasing over time or decreasing?
There are also other risks that can impact the markets that are more sudden. These can seem to come out of nowhere. These include things like the flash crash that we saw in 2010. An idiosyncratic company failure like Enron declaring bankruptcy, or an unexpected outcome like the Brexit vote in 2016. When a risk seemingly comes out of nowhere there is less expected by the markets and the way it’s digested can sometimes be harder to decipher. The market is analyzing it in real time and a pandemic, the coronavirus namely, falls into that latter category of something that wasn’t necessarily expected and we alone with many investors are seeing how it’s going to impact markets economies around the world and if there’s any shifts we want to make in our portfolios. Kate, can you talk a little bit about where we’re at right now.
Well, it’s spreading. I think everybody is watching the news to see where there are more cases and geographically how it’s running. I think really one of the most important things that we’re paying attention to is what sort of actions are being taken to stop the spread. These are mostly preventative actions and they are having an economic impact and they will continue to have some economic impact. China put Wuhan on lockdown, but have also had all across their country they have got limits on people’s movements. They’ve closed factories or reduced shifts. Other countries, including the US, have halted flights or planned to have flights continue to be halted for some time.
In Italy, just this weekend carnival was cancelled and they’ve even canceled parts of Fashion Week in northern Italy as they’ve seen a spat of outbreaks there. Right, and in terms of what the economic disruption is likely to be all around the world, not just in China, that’s a good geographic location to focus on. Austria, Southern Germany and Northern Italy is a somewhat integrated industrial region and so to the extent that Italy is closing things down Austria is, I think right now, considering closing the border. They had two people come in that were suspected to have coronavirus, they did not test positive, but they’re still thinking about closing the border.
So closing borders, container shipping. Container shipping companies have reduced their spring availability by about 30 ships, which I think for the West Coast, we’re talking about between China and the West Coast, adds up to maybe 10 to 15 percent of the capacity. So, that would be a 10 to 15 % decline there along with air routes being cancelled, borders being closed in the Middle East between Iran and Iraq, and a number of other countries. They are being very careful how they allow in particular tourists who are coming for pilgrimage to cross borders.
So, I think all of those things together are indeed going to slow down industrial production. They’re going to slow down economic activity generally as we talk about different kinds of risks. Also, there is the more measurable risk to economic activity and you’re talking about that the fact that there’s less factories are closed they’re not producing. If container ships are being taken offline, goods are not being moved around the world.
There’s another element of risk too which is the psychological risk; the fear that can exacerbate an event like this. And, I think of that when you mentioned border closures, it’s a big one that that really sparks a different level of fear and a lot of residents and in the EU one of the founding tenants of the EU is the freedom of movement of people. So if we’re talking about a closure and closing of a border between Austria and Italy it’s akin to Nevada closing its border and not letting people from California in. It’s a union of countries in this case that have standing agreements in place for the freedom of movement and that is being challenged in an event like this and the ability to enforce quarantines. Right, and if we bring it closer to home in California, one of the preventatives that is in response to psychological risks is the canceling of many different conferences and we’ve seen this globally as well as you mentioned in Italy there are a lot of tech conferences other conferences that producers have simply elected not to pursue so that people aren’t travelling, people aren’t gathering, and there’s less possibility for the virus to spread.
You mentioned factories closed or production slowing ultimately if you have enough inventory to get through a short term disruption this can be not so bad and what you end up with is a delay in production rather than a true loss of production and a true decline in trade. I think depending on how long this lasts, and we don’t know yet, will depend on how much actual impact there is to the GDP of various countries around the world and ultimately to the global growth numbers.
Based on early readings or prognostications around global growth and the impact there how are markets reacting to this? Well, you know it’s funny, because last week we had our internal market review and we talked about the fact that there was cognitive dissonance going on in the markets where we had this potential for really significant global impact, unknown, of course, but markets, stock markets, were behaving as if nothing was wrong. But that changed this weekend. Global markets are down significantly. three to four percent generally, and that’s brought the US market back to being flat for the year emerging market indexes are down about 10 percent for the year, so the impact there has been more significant you know. We see this is this is a good thing because it’s a rational response to uncertainty and to the possibility that we really could have a long-term economic impact from the virus. You know one other thing – you know how China’s position is in the global economy is very different than it was the last time a virus came out of China with SARS in 2003.
That’s right there’s a lot of comparisons easy comparisons being made between the corona virus and the SARS epidemic that took place in 2003, and there’s two main ways that they’re different. The first one is that the viruses themselves are different, not only in scale and impact, potential death rates on them, but also who they’re happening to and when. So we were just looking up in 2003 China represented 8.7% of the world GDP. A sizable figure certainly an important economy in the global landscape. In 2019, they represent 19.3 % of global GDP, so almost one-fifth of global GDP is directly coming out of China. So, a more impactful epidemic potentially pandemic like coronavirus now in 2009, 2020 has the potential to be a lot more impactful than what we saw from SARS or even other past epidemics around the globe making those risky comparisons at best.
Markets really are reacting. It’s not just the stock markets that are finally behaving rationally gold is being pushed up as people feel more cautious, oil has dropped significantly in part because China’s demand for oil is likely to go down, but also because global demand overall should decline in a situation of declining economic activity. So we’re talking about this is a specific kind of market risk one was that was more difficult to forecast or see coming. Markets, despite having retained some strength through much of this year, have finally started to press in some more potential risk here we’re seeing some declines in stock prices in the U.S. and around the globe as we were just talking about. Does this result in any changes in portfolios for clients, are there actions to be taken here?
I know that’s a question a lot of people have on their minds: should we do anything? To start with, our clients’ portfolios are positioned for a range of outcomes. When I say a range of outcomes, that means a range of economic news, a range of market behavior so that they are resilient in various circumstances. We currently do have a fair amount of downside protection built into our allocations. Ultimately, one of the ways in which we will react to this is, if market prices continue to decline we will ultimately be rebalancing the portfolios in a way that that buys in at lower prices. We are invested for the long term our clients have long term needs and so being able to make even some marginal purchases at lower prices ends up being a net positive. One other thing I was thinking about with this is that the reaction to the coronavirus has been pretty dramatic. Once the information had come out of China and globally there’s a lot of preventive action going on and ultimately that preventive action is effective. The short-term declines that we see may only end up indicating a delay and really only a small decline in overall economic activity by the time we get to the end of the year. If it gets worse and worse and closures and shutdowns and all of that continues significantly longer the impact could be a good deal worse. We’ve seen global pandemics before and ultimately their impact on markets has been fairly muted in fairly short term. As I say with this one, if it does go on for a significant period of time and it’s not brought under control, it could be more damaging. But, for the moment we don’t have reason to expect that it’s going to be a terrible situation.
On that on that topic, I was noting that this past weekend Warren Buffett released his annually anticipated letter to shareholders and in it and he talked about variety of things but, he did touch on coronavirus and general risks to the market. He said “If you’re buying a business and that’s what stocks are you’re going to own it for ten to twenty years. The real question is has the 10 or 20 year outlook for American businesses changed in the last 24 to 48 hours.”
And, we think the answer to that is no.
Precisely. We always anticipate short-term volatility. We don’t necessarily know what the sources will be. But, in terms of a long-term diversified portfolio we still think that portfolios are in a good spot. In the long term, we remain very optimistic about domestic markets and global markets and our position for growth over that period of time. And with that we thank everybody for joining us and we’ll see you next time.