Friday, 28th of February 2020
“I do it a lot, anyway, as you’ve probably heard: Wash your hands.”
– Donald Trump
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The age of innocence has truly gone in financial markets. The slide that began last Thursday gathered momentum this week, giving us the worst 5-day period for equities since October 2008. The S&P 500 is down just shy of 11% since last Thursday’s close (with futures forecasting another 2%+ drop for Friday as we write this letter), while the STOXX 600 was down just under 10%, not including the 4% drop seen on Friday so far. This has pushed every single major equity index that we track into negative territory YTD, with the record highs reached only last Wednesday now a distant memory. Deutsche Bank pointed out that the correction seen in equities over the last 6 sessions is actually the fastest 10%+ decline from a record high in the last several decades of data. As you might expect, investors have flooded into government bonds and yields have collapsed in response – the US10Y yield has now touched 1.19% and the 10Y Bund is at -0.62%. What a week.
The cause of this has, of course, been Covid-19. While seemingly happy to ignore the virus when it was “safely contained” in China and neighbouring Asian countries, it has turned out harder for markets to remain sanguine with the virus closer to home. As of writing, cases have now popped up in 48 countries, with over a dozen reporting their first cases within the last 2 days. Of particular concern to the market, and the catalyst for this week’s sell-off, was the rapid acceleration of infections in Italy over the weekend. At the same time cases have emerged in California, Brazil, and Nigeria. Many of these instances can be traced to travel to an infected region, but some appear to be of unknown origin.
We are far from experts on virology, but, through multiple discussions with expert epidemiologists, the base case remains that things are likely to get worse before they get better. Indeed, the number of cases is now growing faster outside of China than within. Part of this is due to the seeming effectiveness of China’s containment strategy. Guangdong, the region with the second most cases after Hubei, has just become the 6th region in China to downgrade its coronavirus emergency response level from the highest level. However, it is simply not feasible to expect Europe or the US to implement the same measures that the CCP was so quick to enforce – the isolation of entire infected regions is not something that is going to fly in the West. Freedom of movement within Europe is going to be particularly hard to curtail, with cross-border travel so ingrained in the lifestyle. Italy has already become the unlikely epicentre of the virus in Europe, with many of the outbreaks in other countries traced back to holidays in the region. At the same time, the outbreak in Nigeria – the first confirmed case in sub-Saharan Africa – does not bode well for such a densely populated region with limited medical facilities.
More information about the nature of the virus itself is also making containment look increasingly challenging. Covid-19 has proved to be transmittable before symptoms start showing, meaning simply quarantining those exhibiting symptoms will not be sufficient to prevent it spreading. It is also likely that the number of cases globally is much higher than reported (~83,000 as of writing), with many mild cases likely to remain undiagnosed. On a slightly more positive note, this does mean that the fatality rate looks to be well below the 3% reported previously, with new estimates coming in at 0.5-1%.
Based on the uncertainty and potential for significant deterioration in economic activity and corporate earnings, we do not feel this is a “buy-the-dip”. As the virus continues to spread, we will see the impact manifest itself in the economic data, which will not to be seen without a significant lag to actual events. Indeed, we have already seen a raft of companies revising their 2020 guidance downwards due to the coronavirus, starting with Apple but with the likes of Microsoft and AB InBev joining the ranks this week. While some are calling for a V-shaped recovery, we think this is less likely – much of this demand has simply been destroyed, rather than delayed. Looking at AB Inbev, they announced that revenues from China for the first 2 months of 2020 came in nearly $300mn short of expectations. Beer not drunk due to Friday nights spent quarantined is not the sort of demand that gets backfilled. At the same time, supply chain disruption is likely to get worse with cases on the rise in manufacturing hubs throughout Asia. South Korea, a particularly important link in the global technology supply chain, now has cases exceeding 2,000. Even within China, where many factories outside of Hubei are now resuming production, a surprising number of phone and car manufacturers have had part of their capacity repurposed to produce face masks.
We are also cognizant of the growing risk to markets posed by Bernie Sanders. With Super Tuesday coming up next week, Sanders is looking increasingly likely to win the Democratic candidacy and the latest polls are actually showing Sanders beating Trump in the presidential election. While we know how good a predictor of outcomes election polls are (the answer is not very), the coronavirus is taking centre stage right now and the recent robust economic data coming out of the US has gone unnoticed. Indeed, the potential for coronavirus to spread throughout the US and disrupt economic activity could prove disastrous for Trump’s campaign. We still think that Trump will win, but feel that the possibility of a socialist president pushing for the break-up of big banks, Medicare for all, and higher taxes is not something that can be ignored. The President also tried (in vain) to reassure the markets this week by tweeting that “the Coronavirus is very much under control in the USA” and that “stock Market starting to look very good to me”. While history shows that American Presidents have the ability to move the stock markets when urging investors to buy, it might be the exception that proves the rule this time.
However, despite all the risks, we are reluctant to divest from the market further given the speed with which things can change. Although a vaccine isn’t expected for many months, anything is feasible and the appearance of one would certainly do much to calm investors’ frayed nerves. It is also possible that government or central bank stimulus could put a floor under the slowdown. We have already seen South Korea’s government launch a targeted stimulus package to support their economy including a wide array of consumer subsidies and, while their central bank did not cut rates on Wednesday as many expected, this could partly be due to 2 (arguably unnecessary) rate cuts last year. We could easily see further cuts across many developed and developing economies this year, even with benchmark rates already plumbing record lows.
As such, we will continue to maintain our defensive positioning, which has given portfolios a good deal of protection in this period of uncertainty. Gold is now trading at ~$1615/oz, well above the levels of Q4 2019 when we saw markets becoming increasingly complacent. Gold equities have also proved resilient to the tremors in the broader equity market (and remain positive YTD), though some level of beta is inevitable when investors are looking to liquidate just about everything they own. Lastly, Put Options on the S&P 500 have provided a nice buffer on the back of the sell-off and a significant pick-up in volatility.
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