From an email sent on March 4, 2020:
Good evening, IIM investors.
Below are some thoughts from Retz and I about the coronavirus. We hope they help answer your questions.
First, though, for Tarpon Folio investors in particular: I’d like to make another plug for the IIM Investor Message Boards. Energy markets have been especially volatile of late, and if you’d like to better understand how I’m thinking about Tarpon here, I’d recommend a peak at the Boards, which you’ll find here:
Please let me know if you need a new login.
Now, on to some general thoughts about this virus…
For the past two weeks, markets have been obsessively focused on the spread of the coronavirus, officially referred to as COVID-19, and its impact on the global economy. Government efforts to contain the spread of the virus have already impacted economic activity in China and other parts of the world, creating significant economic uncertainty. This has resulted in a stock market pullback that some have referred to as the “coronavirus correction” and “virus volatility.” While much ink has already been spilled on the topic, investors naturally still have many questions about what lies ahead from a long-term perspective.
There is perhaps no topic that can inspire more public fear and panic than a viral outbreak. Too many zombie apocalypse movies. It’s for exactly this reason, though, that investors should continue to maintain level-headed and see through short-term noise. And in order to objectively understand what these issues might mean in the long run, we think it’s helpful to untangle the topics of public health, the global economy and recent market reactions by addressing the following questions:
How widespread is the coronavirus? How have markets reacted to past epidemics/pandemics? Will coronavirus cause a recession? Why did the Fed cut interest rates? How might the market respond in the coming months?
Retz and I both feel very strongly that it’s important for investors to maintain perspective in times of uncertainty. After all, the goal of long-term investing is to achieve financial goals over the course of years and decades. What happens in the intervening days, weeks or even months is not only much less important – but overreacting to these events can actually be harmful. Simply put, investors who stay disciplined are much more likely to succeed.
The coronavirus has spread quickly since the end of January and is now reportedly on every populated continent. Since most investors (including ourselves) are not public health experts, the spread of coronavirus is highly uncertain and difficult to analyze. So we’ve gotta rely on expert opinions and published data…while not jumping to conclusions.
At the moment, the data show that confirmed cases continue to rise globally but are slowing in China. The mortality rate, as reported, has been in the 2-3% range, depicted as the shallow red line on the chart above, with most deaths occurring for those who are elderly or have pre-existing conditions. The corresponding recovery rate has been high and rising. The overall numbers are magnitudes smaller in absolute terms compared to the seasonal flu, although the mortality rate is significantly higher.
So, although it’s still unclear when and if the virus will be contained, the bigger challenge from a markets standpoint is the potential for unnecessary fear and panic. Viral epidemics are by their nature scary subjects and, in our everyday lives, it’s difficult to not react. When it comes to our investment strategies, however, panic is the least useful emotion. By far.
Understanding the history of epidemics and pandemics helps to provide some limited guidance. Prior episodes over the past two decades, including SARS, avian bird flu, H1N1, MERS, Ebola and Zika, resulted in public attention but had few lasting market reactions. In fact, other factors played much larger roles in each episode.
The chart above highlights these cases and uses Google Trends data to pinpoint the periods of peak public concern. In each case, markets dipped briefly – often for other reasons – before recovering over the coming months and quarters.
These “other reasons” are important. The SARS outbreak occurred in the wake of the tech bubble which affected markets for years. Avian influenza occurred during the housing boom, MERS and Ebola during the Eurozone crisis, and Zika coincided with an oil price crash and period of concern over Fed rate hikes.
Even today, with coronavirus front and center in the headlines, investors have been concerned about cycle-high valuations, slowing earnings growth and the presidential elections. So, while it may be convenient to pin a market pullback on one specific cause, in reality there are always many factors at play. Investors should continue to watch longer-term trends around the economy and company fundamentals.
Of course, these past cases were of smaller magnitudes with mostly localized impacts. Still, history suggests that unless there is a serious disruption to the structure of the economy, growth can recover and markets can move on.
The effort to contain the spread of coronavirus in many countries has already had an impact on supply chains. The outbreak in China also coincided with the lunar new year, effectively prolonging the period during which industrial activity was shut down. U.S. companies have been reporting supply disruptions over the past two months as a result.
This slowdown can be seen in the February economic data. The chart above shows indicators of manufacturing activity in China and the U.S., both of which have decelerated recently. In China, it should not be a surprise that activity contracted last month due to whole cities being quarantined and companies shutting down. What would be surprising is if this continued to be the case once factories are back up and running.
Global GDP forecasts are also beginning to reflect this lost output. The chart above shows consensus GDP forecasts as well as the OECD’s forecast for global growth in 2020. The OECD has recently warned that growth could slow further, possibly to 2.4%.
It’s undeniable that growth has decelerated due to lost economic activity. However, a one-time loss of output is very different from suggesting that there will be a prolonged recession. If coronavirus can be contained, or if recovery rates are high enough for people to return to work, then economic activity can get back on track – even if it takes some time. In textbook economic terms, this may be a classic “shock” to the system that causes a short-term decline in growth which is often followed by a rebound.
For long-term investors, the U.S. economy is still fundamentally healthy. Despite the coronavirus, unemployment remains near historic lows, inflation is still tame, and corporate activity is vibrant. Despite short-term fear and concern, the data does not yet suggest that these trends will change.
In response to the short-term economic data above, and in an effort to be cautious, the Federal Reserve announced an emergency interest rate cut of one-half percent yesterday. This was the first emergency move by the Fed since the 2008 global financial crisis and took place two weeks ahead of their scheduled mid-March meeting. At the moment, the federal funds rate sits at a range of 1 to 1.25% – a level last seen in 2017.
It’s clear that rate cuts cannot solve the underlying problems related to the spread of coronavirus – a fact that the Fed understands – nor can it spur activity in all parts of the economy. The best the Fed can do is to bolster confidence and reduce frictions in financial markets. Like their other recent rate cuts, this amounts to an “insurance cut” in that it may help to prevent other problems down the line.
One immediate result of the rate cut was that interest rates across the yield curve declined. The 10-year Treasury yield fell below 1% for the first time ever. The 30-year Treasury was in the 2’s today, as well. So if you ever thought about refinancing that house…
In any case – investors who need portfolio income will need to continue to find it from places other than bonds. But that’s not new to the coronavirus, either.
The bigger issue around the emergency Fed decision is that a 50 basis point rate cut was already widely anticipated. Since 2008, many investors have come to rely on the Fed to bail out the stock market. This is often referred to as the “Fed put” since it is like a put option – which protects investors on the downside.
For long-term investors, however, it’s still more important to focus on economic fundamentals, valuations and corporate earnings. Following the recent market pullback, the overall stock market valuation has fallen somewhat to levels last seen in 2018.
While this is, of course, partially driven by a decline in market prices, it’s important to keep in mind that valuations also take into account future earnings expectations. In other words, estimates of the economic impacts discussed previously are included in these numbers. The fact that valuations have fallen – rather than rising or staying the same – suggests that stock prices have declined faster than earnings expectations. So this implies that are still many opportunities for long-term investors.
Additionally, it’s normal and expected for the stock market to swing in either direction on a short-term basis. In fact, several 5-10% moves in the broa market are quite common each year. The chart above shows that investors have experienced two such moves in recent weeks and that, historically, the average year experiences several of these pullbacks before recovering.
In fact, when the market does recover from corrections, it often does so swiftly and without warning. Those who try to jump in and out of the market to avoid short-term declines often miss the subsequent rebounds. At least two significant positive stock market moves over the past week illustrate this point.
Ultimately, the best way for investors to handle the anxiety and uncertainty caused by things like the coronavirus is by holding an appropriate portfolio. While many global asset classes are in the red two months into the year, the fall in interest rates has also pushed up many bond prices. So, a balanced portfolio has fallen by far less than the overall market…exactly what it is designed to do.
In the end, much of investing is emotional and behavioral. A steadier ride helps investors to stay on track and not overreact to short-term events. So if you feel like there is a significant difference between how much volatility you can tolerate and what you are seeing in your portfolio over the last two weeks, please let us know.
The spread of coronavirus is a public health challenge and may slow the economy in the short run. In the long run, however, investors should continue to stay focused on their goals.
So, while we don’t want to be cavalier about this virus – our advice really is that simple.
This, too, shall pass.
Again – if you’re feeling particularly unnerved by all this coronavirus angst, please let Retz or I know. We can be available to talk it all through on the phone, or meet up in person, at your convenience.