MARKET COMMENTARY

Update: Coronavirus and Portfolio Implications

Ian Riach shares our thoughts on the coronavirus and how we are positioning the portfolios.

03.02.2020 - Ian Riach, Chief Investment Officer

Update

We wanted to update our previous article on the economic impact and risks to global markets from the Covid-19 virus. At that time, we were hesitant about adding to risk in the portfolios, given some of the uncertainties and potentially negative implications of the virus spreading. We felt more aggressive containment strategies would be negative for growth, at least in the short term.

We begin by re-emphasizing the key conclusion of our last commentary on this subject: we believe it is important to maintain diversified portfolios, particularly in times of increasing investment uncertainty, using a process that resists the temptation to trade around news flow and emotion. Instead, we focus on how the evolving macroeconomic backdrop is affecting market fundamentals and adjust our asset allocation views accordingly.

Geographic Impact

There is little doubt that Chinese economic activity has slowed during the first quarter of 2020; it is more a question of by how much. A variety of daily production indicators, such as passenger traffic or daily power coal consumption, signal very little rebound in activity. Business confidence surveys reflecting February activity also confirm the growth slowdown in China.

China Business Confidence Surveys

August 2014-February 2020

China Business Confidence Surveys

Source: Franklin Templeton, Blooberg, Macrobond.

 

Outside China, we can observe that the slowdown in activity is having an impact on neighbouring countries, as illustrated in the chart below (most recent data point reflects February activity).

Coronavirus Impact: Japan Composite PMI and South Korean Consumer Confidence

May 2017-February 2020

Coronavirus Impact

Source: Franklin Templeton, Blooberg, Macrobond.

 

While it makes sense that Asia is most impacted, the evolution of the virus suggests that other regions are at risk, resulting in decreased consumer and business sentiment.

The US information technology sector is particularly vulnerable due to supply chain disruptions from Asia. But even more domestically focused sectors like consumer-related sectors and financial services would be vulnerable if the virus were to spread more widely in the United States. These will need to be monitored closely.

Duration Impact

The virus is difficult to contain, as symptoms can be mild and similar to the normal seasonal flu. While there is still a possibility that China sees continued deceleration in cases, this remains an open question as many workers are returning after an extended break and are starting to resume normal activity, which will render containment more difficult. Globally, it seems likely that more clusters will emerge. Ultimately, this means the duration of the impact will likely be longer than previously envisioned.

Response Impact

Our expectation has always been that this growth impact would be met with a proportional policy response. So far we have seen many policy responses across the globe and we believe more are will come in short order. Falling oil prices and the low inflation backdrop will allow global central banks to maintain or extend stimulative monetary policy, which is more aggressively being priced into market expectations for official interest rates.

Fed Dot Plot vs Futures Curve

Dot Plot as of January 2020 Meeting
OIS as of 2/27/2020

Coronavirus Impact

Source: Franklin Templeton, Fed, Macrobond.

 

We also want to consider how policymakers will respond to the virus itself. Measures such as quarantines and travel restrictions are also being imposed and are helpful in containing and preventing the spread of the virus, but come with an economic and social cost.

It is interesting to recall that during the early days of the H1N1 influenza outbreak in Mexico, policymakers initially engaged in quarantines, restricted travel, and more. Eventually, these policies were abandoned due to the economic and social cost. H1N1 is an intriguing case study as the mortality rate turned out to be quite low. We have yet to see if equilibrium mortality falls to a similar level for this coronavirus.

Economic Impact

The spread of the virus is making it more likely that the growth impact extends to the rest of the world. It will be difficult for the US consumer to remain resilient if the virus becomes more widespread in the United States. The policy responses thus far have been encouraging with more expected.

We review the typical pattern for a shock event to markets: concern builds to a point where a sharp drop in confidence and/or activity hits economic data releases (with a lag), the slowdown is discounted in markets, investors show a willingness to look through the near-term concerns and re-establish positions in risky assets given the likely policy response and eventual recovery in economic activity.

In our view, it is too early to tell the full extent of the economic impact or when investor concern will peak, but we have seen substantial discounting in equity and fixed income market prices already. The data will likely get worse before getting better, but it appears markets are starting to price in a fairly adverse scenario.

Asset Allocation Takeaways

From an asset allocation perspective, we continue to prefer regions that have the policy flexibility to respond to a growth shock, such as the United States. Areas like the eurozone, with constrained monetary policy and fiscal challenges, will face a tougher road ahead if the virus spreads further through the region.

Canada, although less susceptible to a coronavirus threat directly, has economic risk through a few main channels; lower energy prices impacting a large part of our economy, an open trade-oriented economy mired in a slowdown in global trade, and consumer vulnerabilities from higher debt levels and lower savings rates. Canada’s policymakers do, however, have more room to counteract a growth slowdown compared to many other regions.

Bottom-line, we would not aggressively add to risk yet, but are looking at marginally adding back to risk given market price action of the last week and the potential policy response. As we look ahead over the next year, we continue to see attractive return potential from global equities and thus are looking for opportunities to increase exposure, such as the significant sell off we have seen this week; but we will do it in a measured way as it is impossible to determine when the bottom will occur.

 

Comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

 

 

Important Legal Information

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

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