Last week was a challenging week in the market as volatility spiked and an -11.5% decline in the S&P 500 marked the worst week since the Financial Crisis. Up until last week, the market seemed to look past any short-term concerns related to the coronavirus in China. As the epidemic spread beyond China and into Italy, South Korea and Iran, there became a greater awareness that the downside risks are higher than previously anticipated. Fears that supply chains will be disrupted, and consumer activity will slow, are now creating more uncertainty around the severity of the economic impact stemming from coronavirus.
The coronavirus epidemic is at a stage where no one yet knows what its significance will be on the global economy. Many are beginning to discuss measures that could be taken to protect citizens from the virus, some of which could lead to slower consumer spending. Supply chain disruptions are a real threat, but again the magnitude is not yet clear. Roughly half of Chinese manufacturing has now come back online, having been idle since the start of Chinese New Year. Apple, which had previously signaled coronavirus was hampering production, has stated they are now working to get back to full production.
We know there will be more reports of new cases of the virus and fears will remain over the near-term. However, given the information available to date, it seems more likely than not that coronavirus will have a transitory impact on the economy. However, the depth and breadth of how the virus is spreading will guide our assumptions around the speed that the economy can rebound. At this point, by our estimates, the impact from China alone is likely to cut global GDP by 0.5% to 1.0%. Our working assumption is that this impact will hamper the global economy in the first half of 2020, as we look for a rebound in the second half of the year.
The Market Reaction
The fact that the S&P 500 was down all 5 days last week, and has declined 7 days in a row, resulted in a particularly grueling experience. However, its important to keep things in perspective and the market is now trading where it was in mid-October, a mere 4 months ago.
The magnitude of last week’s sell off seems well within the range of reasonable outcomes. Corporate earnings results are clearly going to be lower than the market consensus had expected at the beginning of the year. Most analysts have yet to take down their expectations as they are waiting on more guidance from companies; who themselves are still deciphering the impact. These lower expectations justify lower share prices. Having such a swift reaction all in one week, however, is not particularly pleasant.
A note of optimism came on Friday as markets rebounded strongly into the close. While the S&P 500 finished negative on the day (although the NASDAQ was positive), the buying pressure into the close was a sign that buyers may be willing to step in. In addition, high yield bonds, which had suffered all week, experienced a positive day demonstrating a desire for risk taking within the bond market.
During this past week, risk assets (stocks, corporate bonds, etc) sold off indiscriminately, as investors made a flight to safety into assets such as Treasury bonds, which did particularly well. This type of behavior is typical when there are swift shifts in investor sentiment. Coming out of the initial sell off is when opportunities tend to present themselves, as not all assets are created equal and there should be dispersion in returns.
It’s unlikely that the volatility we experienced last week is completely over. However, we do feel the risks, as we see them today, are more reasonably reflected in share prices.
Market participants are beginning to watch for action out of the Federal Reserve and other central banks. Fed Chairman Powell stated on Friday that the Fed would act appropriately to support the economy. In our view, the market is expecting some accommodation out of the Fed and has already reflected this assumption into lower interest rates throughout much of the yield curve. There does not seem to be a sense of urgency for the Fed to act, and with their next scheduled meeting not occurring until mid-March, they have time to gather more data. Although it is plausible they could act ahead of their scheduled meeting or act in concert with other central banks to lower rates or provide other accommodative policies.
Telemus’ approach to constructing portfolios is to be long-term minded, but conscious of short-term opportunities. We allocate assets based on our long term expectations, encompassing a full market cycle (typically 5-10 years). During a market cycle, we expect down weeks, quarters and years and account for that in how we construct and stress test client portfolios. Diversifying across multiple asset classes and considering how they will act relative to one another in different environments is paramount to our approach. Diversification did its job last week, as portfolios allocated to stocks, bonds and alternative investments held up better than the broader equity market. Even after a week such as last, we still like how our clients’ portfolios are positioned, although we are always on the lookout for opportunities that will improve the risk/reward profile for our clients.
Over the past year, we have become more defensive in portfolio positioning. Within the equity component of the portfolio, we added more defensive equity investments removing those that had greater economic sensitivity. Within bond allocations, high yield and corporate bond exposure had been reduced, with greater allocations to mortgage and Treasury bonds. More recently, we trimmed some equity exposure and held it in cash-like, short-term bonds.
Given the uncertainties that remain around coronavirus and the global economy, we do not believe that now is the time to take increased risk. However, during sell offs like we have been experiencing, dislocations in asset prices tend to present themselves. Our Investment Committee is actively looking for these opportunities and would look to incorporate any such opportunities in a manner that wouldn’t increase our client’s overall level of portfolio risk.
What had been an unknown risk in the coronavirus has changed the expectations all investors had when 2020 began. While the downside risks have risen over the past week, they are now more adequately reflected in stock and bond prices. Episodes of volatility are likely to remain over the near-term, however dislocations and opportunity will present themselves. In periods such as this, knowing your risk tolerance and having the appropriate balance of stocks, bonds and alternative investments is important. Diversified portfolios are not immune from losses, but they are designed to help investors weather the inevitable market downturn in a managed manner. We encourage investors to look beyond the short-term noise that will be created from the Coronavirus. The media hype over the past week has created a lot of concern around uncertainty. We are focused on understanding the facts and deciphering how these should and will impact the economy and ultimately the markets. Focusing on the long-term and not reacting to short-term uncertainty is the best way to weather storms such as this.