Everyone has a plan, until they get punched in the face.
– Mike Tyson
Until its closure in 1989, Britain operated a research facility called the CCU (Common Cold Unit) with the objective of researching the common cold to identify ways to reduce its human and economic impact. The CCU ran several interesting experiments during its time. In one, a volunteer was fitted with a device that leaked a thick fluid at the nostrils at the same rate that a runny nose would. The test subject then socialized with other volunteers, as if at a cocktail party. Unknown to any of them, the fluid contained a dye only visible under ultraviolet light. When an ultraviolet light was switched on after they had been mingling for a while, the participants were astounded to discover that the dye was everywhere — on the hands, head, and upper body of every participant and on glasses, doorknobs, and bowls of nuts. The average adult touches their face 16 times in an hour and each of those transfers spread the pretend pathogen.
It's this frequent contact between humans that has resulted in over 80,000 cases of the novel coronavirus (COVID-19). We are by no means suggesting a global pandemic but given the ease of contamination of the coronavirus, we believe that the unintended consequences will have larger near-term economic consequences, and investors are starting to price in that risk with vigor.
As of market close on February 26, 2020, we have seen the equity markets around the world fall as investors price in the increased economic risk of the coronavirus. The S&P 500 Index, S&P/TSX Composite Index, and MSCI EAFE Index are each down 8.0% (USD), 4.9%, and 6.8% (USD) from their recent highs. Commodities such as oil and copper have fallen 22.9% (as measured by West Texas Intermediate price per barrel in USD) and 10.6% (USD) from their respective highs. Bond markets that had been pricing in risk since before the start of the year have rallied with the US 10-Year Treasury Yield, making a new all-time low. While investors were largely heedless as news of the coronavirus dominated headlines in the early weeks of February, it took a breakout of the virus in Italy for investors to finally acknowledge the risks. We are now seeing pricing-in of the economic disruption across equity and fixed-income markets.
We are not in the risk-predicting business. We are in the risk-managing business.
– Daniel S. Janis III
We can’t predict risk. We can’t predict what the catalyst for a correction may be. All we can do, as Dan Janis, Senior Managing Director and Senior Portfolio Manager says, is manage risk. Our expectations for equity market returns in 2020, before news of the coronavirus, can be characterized as mid-single digits or below-average to the upside with average downside risk. By our preferred measures, the S&P 500 Index was fully valued and earnings growth expectations were modest, at best. That is to say that equity markets were overpricing earnings growth expectations that we didn’t think were possible in the first place. Now markets are faced with the economic disruptions of the coronavirus on both the supply side in, terms of manufacturing shut-downs, and also demand as consumers retrench, travel less, buy less, etc. Companies such as Apple and Microsoft have lowered their guidance for revenues and earnings as a result. The economic impact of the coronavirus can only compound the risks.
For the time being, we believe the U.S. economy may be the least sensitive to the economic fallout of this virus. That doesn’t mean though that the economy will be firing on all cylinders. Fourth quarter GDP growth for the U.S. economy was reported at an annualized rate of 2.1%. This number is entirely irrelevant to today’s situation. By all accounts, we expect manufacturing activity that showed a modest rebound in January, as measured by the ISM Manufacturing Purchasing Managers Index, will contract in February. Further, don’t expect a restocking of inventories to save the day. Manufacturing inventories as a percentage of sales have been climbing in recent months. The data, as of December, shows the highest inventory-to-sales ratio since 2016. This is only likely to climb in the current economy, calling into question the timing of any sustained manufacturing recovery.
Additionally, the team’s view on the return expectations for the S&P/TSX Composite Index has changed due to the impact of the coronavirus on oil prices. As highlighted in “Oil and the bullish case for Canada,” one driver of our team’s view was earnings growth of at least high single digits for the S&P/TSX Composite, driven by an average price of West Texas Intermediate (WTI) of US$65/bbl. While there are many uncertainties surrounding the economic impact of the coronavirus, there’s less doubt about its impact on energy prices. The International Energy Agency (IEA) slashed its Q1 2020 global demand forecast by 1.3 million barrels per day, and if it’s correct, it would be the first year-over-year drop in demand in more than a decade.
China accounts for more than three-quarters of growth in global oil demand, according to the IEA. Morgan Stanley has measured China’s pollution level as an effective way to measure whether China’s cities were returning back to normal. What they found was that, among the top cities (Shanghai, Chengdu, and Guangzhou), air pollution was 20-50% of the historical average. With quarantine measures expanding broader geographies and for longer durations, it’s likely that the demand for oil will face continued headwinds. According to the International Civil Aviation Organization (ICAO), 50 airlines have significantly cut back operations, while 70 have fully cancelled all international flights to and from mainland China. This has led to nearly an 80% reduction of foreign airline capacity for travelers to and from China. An estimate for the price of crude (WTI) to average US$55/bbl this year would suggest flat earnings growth for the S&P/TSX Composite Index through 2020, whereas pre-coronavirus oil prices and, therefore, earnings growth was expected to accelerate. As a result of the disruption in oil demand, we believe the opportunity set for Canada has been delayed by one or two quarters, at best.
In Europe, where those countries have closer economic ties to China, and given the increasing number of cases in countries such as Italy, the economic consequences may be similar to Asia’s. Heading into January, European Industrial Production continued to slow in an already slower Chinese economy. In fact, given that global exports were still showing strain from the US/China trade war in December, the current supply chain disruptions will only delay the recovery. Any rebound in Europe will be contingent on a rebound in China. In the meantime, we believe the German economy will be prone to recession, and earnings growth, overall, will continue to be modest, at best.
The catalyst of corrections is unpredictable. Corrections — a drop in equity markets of greater than 10% — are fairly common. Bear markets — a drop in equities of greater than 20% — tend to be more associated with recessions. Since World War II, only three bear markets occurred outside of a recession (1962, 1966, and 1987). We would not suggest the current market volatility is attributed to a pending recession, as we don’t believe there’s enough evidence of such an economic consequence at this time. And, therefore, we wouldn’t suggest the current volatility will materialize into a full-blown bear market. At the same time, we wouldn’t embrace the “buy the dip” mentality that has permeated the market over the past number of years, as the current economic and market conditions demand careful consideration.
Corrections can be sentiment driven, where market volatility is merely a “blow-off” from the top, or fundamental driven (for example, the fourth quarter of 2018 where markets were repricing based on a higher rate environment). Historically, we’ve seen a bottom of a correction marked by the Volatility Index breaking above 30. In this case, however, we would suggest the volatility is a combination of sentiment and fundamental drivers, and that the coronavirus is both catalyst and cause of the market volatility and unlikely to subside in short order. We would not be as quick to buy the dip and increase risk assets in a portfolio this time around until we feel more confident in the economic and earnings environment.
Over the last 8 months the Capital Markets Strategy team has held the belief that equities, in general, were fully valued to modestly over-valued across many markets, with very modest earnings growth potential. With this, we held the view that the market expectations were well ahead of the market potential and, since June, have been reflecting that with a 10% underweight to equities in our model portfolio (based on a 60/40 equity/fixed-income benchmark). Our offset to the underweight in equities is an overweight in bonds — both defensive core bonds and high-yield. Bonds have held in well during the volatility and markets are pricing in a rate cut by the Fed before June.
We suspect it was the narrative of TINA (There is no alternative) or FOMO (Fear of missing out) that drove equities higher leading up tothe week of February 17, 2020. We believe a better acronym of WITA may serve investors well — What is the alternative? When put in this context, why would an investor buy a bond that pays 1-3% over an equity that historically generated a higher annual return? It’s because, over the short term, 1% is always better than a drop of 10%. While we wouldn’t be adding to equities on this volatility yet, neither would we panic and reduce our underweight to equities further. We would need to see greater risk of recession for a more defensive posture, and that doesn’t exist yet. In hindsight, a defensive posture ahead of the current volatility was a prudent approach to asset allocation, and in light of the economic environment and until signs of improvement, remains so.
Macan Nia, CFA
Senior Investment Strategist
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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