Over this past weekend, the threat of Coronavirus began to feel very real for Ontarians with expedient school closures and work-from-home protocols in-force. In the past 48 hours, we have been inundated with expressions like “social distancing”, “panic buying” and “flattening the peak”. It may be difficult to focus on the outlook for financial markets when the welfare of our clients, family and friends is top of mind. Nevertheless, putting events that affect the markets into perspective is an important responsibility of ours – in good times and bad. As a result, we wanted to share our key thoughts on this developing situation.
At least 114 countries have been drawn into the crisis, and many are still in its early innings. Giving hope and guidance are China, South Korea and Japan whose reports of new infections began declining two to five weeks ago and are showing signs of flat-lining. A cycle seems to be forming where there are two weeks of rapid new infections, a peak, and then consistent daily reductions of new cases. The key variables that differentiate the length of these cycles include the health of the existing health care system, how quickly mitigation steps are put in place and the ability to effectively isolate and raise hygiene standards. Beyond the threat that this virus has had on our local populations and economy, the threat to developing countries with fewer resources is even more dire. Therefore, it would be naïve to believe with any certainty that we have already seen the lows or the peak of market volatility.
Dr. Scott Gottlieb, a former FDA Commissioner, believes the coronavirus will peak in the US from around late April to early May. This means weeks and possibly months of negative headlines and more patience is needed from North American investors. The likelihood of a recession, defined as two-quarters of negative GDP growth, continues to increase as supply chains are disrupted, business and travel are suspended and consumer spending grounds to a halt. With all this said, the key question remains ‘When is this going to be over?’ and not “If” this is going to be over. Like most biological crises and health care scares, the expectation is that containment will be achieved.
In an environment like this, the ways of fundamental investing go out the window. Looking at PE valuations means relatively little when there is little consensus as to what earnings will actually be. Moreover, even if one were to stick to fundamental investing, markets tend to overshoot whatever you think the fundamentals justify. This is how we end up with neck-breaking market drops of 30% within 3 weeks and 10 trillion dollars of lost market cap despite the disproportionate expectation of a $500 billion loss in US Q1 GDP (JP Morgan Research).
RBC GAM research put out a note in which following every crisis, correction, crash and bear market, the prior peak in earnings for the S&P500 had eventually been achieved and usually within 3 years. Being that this crisis is not a financial/structural crisis, investors cannot be faulted for expecting the recovery period to be faster once the health scare has ended. Hence for many investors who have been through major market downturns before, the tendency is not to sell into a panic. In the past, this has yielded stronger and faster recoveries.
If we are to assume that this virus will be contained, then it is fair to assume that fundamental investing will return and replace the psychological fear that is currently abundant. When performing fundamental analysis of a stock’s price, it is typical to add up the expected future cash flows of a corporation and include a ‘terminal value’ that captures the value of a business in perpetuity. These values are then discounted to come to a stock price in today’s dollars. Regardless of what numbers one uses, it is baffling to witness stock price drops that are reflecting much more than just a couple quarters or even a full year’s worth of lost earnings and cash flow. Hence, value is being created at these levels, and our belief is that patient investors will eventually be rewarded.
When the crisis clears, Investors should also recognize the wind behind our sails that can help lift markets higher. The economy will gather additional strength from four sources.
- Recapture of the activities and spending that were deferred and delayed
- Interest rate relief for consumers and businesses
- Fiscal programs to boost economic activity
- Lower energy costs that reduce input costs for consumers and businesses
Ultimately the key will be whether Governments can put in the appropriate policies and stimulus to help maintain the purchasing power of businesses and consumers for when the crisis subsides. Thus far we have seen drastic interest rate cuts, a restart of ‘quantitative easing’ and a massive boost to the ‘overnight repo’. Without getting into details and definitions, this is all to say that the priority of governments is to ensure that the economy will have unlimited amounts of liquidity, low rates and access to necessary capital to ensure businesses can survive. At the time of this writing, Premier Doug Ford recently promised job protection for employees who are unable to work due to isolation, quarantine, or to care for children due to school closures. This is retroactive to January 25 and will remain in place until Covid19 is defeated. Measures like these will help fortify the purchasing power of the consumer, which will be important to return the economy back to its original state of health. Therefore, although monetary and fiscal policies may not impact consumer behavior immediately, they are instrumental to the recovery and we intently await more.
In the meantime, through all the volatility, our PIM and A+ portfolios continue to make tactical rotations to manage risk and follow a rebalancing discipline to dollar-cost-average. By resetting the asset mix to fit long term targets and making new purchases in stages, portfolios are better positioned to benefit from a market recovery. Volatility is hard to take in the moment, but an appropriate time horizon is essential to a plan’s success. Beyond those assets earmarked for immediate liquidity needs, portfolios should remain invested to meet their longer-term financial plans.