Global markets are reacting strongly to the spread of the COVID-19 virus. As of this writing, the U.S. equity market, as measured by the S&P 500, is down 13.9% (total return) from its peak on February 19. At the same time, bonds have represented a safe haven with the 10-year U.S. Treasury yield at an all-time low level of 1.16%. Though not significantly, the dollar is down and foreign equity markets are down nearly in line with U.S. stocks.

We wanted to share our perceptions of the COVID-19 virus, not from a public health perspective but based on our decades of experience in the markets and working with clients. Even here however, it is difficult for anyone to try to rationally assess the uncertainty of this continuously unfolding crisis. Contained within the uncertainty are the seeds of a long-observed path of human behavior. Individuals often initially underreact to bad news. When events don’t bear out their insouciance, they can quickly succumb to an overreaction, believing that the worst-case scenario is even worse than current data support. The world may currently be in the phase of over-reaction, while at the same time working hard to assess potential longer-term impacts.

What we do know is that the economic impact of the virus will unfold gradually. The first order effects are those areas of demand that will never be recovered (travel during the Asian Lunar New Year as well as other tourism and near-term consumption). Likely to swamp this are second order issues such as disruptions in supply chains. For example, as compared to eighteen years ago during the SARS epidemic, China has grown fourfold, its factories are integrated into many more supply chains, and global trade is more critical to deliver finished goods to consumers everywhere. The magnitude of the virus’ effect is also derived from human psychology; perceived diminished wealth can lead to lower spending and eventually job layoffs. Consumer demand has become the lynchpin of many economies around the world; a pullback in consumer participation puts a further brake on economic growth.

The most alarming barometer has been the market reaction. Volatility, written off for the past decade, today reached four times its level from earlier this year. That said, even with equity markets down, perspective is worthwhile. The sell-off has been sharp but as of midday Friday has only reverted to the levels of early October 2019, just five months ago. Taking a longer-term view, the S&P 500 is currently up 16.5% annualized since its trough in March 2009; that same measure taken two weeks ago showed annualized results of about 18.3%. Coming into 2020, analysts were expecting U.S. companies to generate earnings growth of 7% for the year. Some analysts now project no earnings growth. Therefore, combining the approximately 14% sell-off in the markets with 7% lower earnings means that stock valuations have broadly come down through this sell-off and are largely less expensive.

Government bond yields have fallen along with equities, bolstering the returns of bond portfolios. Based on market data, the Federal Reserve is back in the picture and likely to be increasingly accommodative this year. Expectations are now for a reduction in the Federal Funds Rate at the Federal Open Market Committee’s next meeting in March with possibly three more reductions before year-end. The value of monetary policy is questionable, and its impact takes several months to flow into the real economy. Its real benefit may be to demonstrate to investors that the government will take action to counteract risks to economic growth. As a result, improved sentiment in the stock market is likely to appear before the real economy recovers.

For fifty years, Bailard has been a strong proponent of diversification. Today’s environment makes diversification’s value clear. Bond prices are up strongly and areas such as real estate may provide some stability unless this downturn becomes extremely protracted. Since early 2009, large-cap U.S. stocks, especially those with high earnings growth, have outperformed the rest of the equity markets in the U.S. and elsewhere. The market may use this set back as an opportunity to positively reevaluate other segments such as smaller and more value oriented stocks. In some cases, we have moved to incrementally more conservative postures over the past couple of weeks. That said, we generally believe our role is to keep our hand firmly on the tiller, recognizing that equity markets can find new footing as quickly as they lost it. Violent periods such as the past two weeks can shift investor perceptions and actions. While we will further reduce risk in our clients’ portfolios if we think it is necessary, we are equally as likely to look for opportunities in the eventual rebound in stocks.

We, like you, remain concerned about the virus’ impact to the world’s population and remain vigilant in our focus of preserving and growing wealth for you through this crisis and always. We, of course, continue to monitor the issue and its impacts to our clients and remain prepared to act with prudence in navigating this situation.

 


This piece has been distributed for informational purposes only and is not a recommendation of any particular strategy. It does not take into account the particular investment objectives, financial situations or needs of individual clients. All investments have risks, including the risks that they can lose money and that the market value will fluctuate as the stock and bond markets fluctuate. The information in this publication is based primarily on data available as of February 28, 2020 and has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation are not guaranteed. In addition, this piece contains the opinions of the authors as of that date and such opinions are subject to change without notice. We do not think this publication should be relied on as a sole source of information and opinion on the subjects addressed. All investments have the risk of loss. Past performance is no indication of future results.

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