Feb 27, 2020 by Matt Bacon
Markets are on a downward trajectory. At the time of this writing the S&P 500 has closed down for the last six consecutive days as Coronavirus fears proliferate. Both the Dow and S&P 500 are now negative for the year. Swaths of China have gone into lockdown as have five towns in northern Italy and more cases of the Coronavirus are popping up in countries that previously had none. Whereas in the initial days of the outbreak it appeared that global equity markets would simply shrug-off the virus, investors now appear willing to accept the constraints that Covid-19 will place on global growth and corporate earnings.
China is the world’s second largest economy and according to the International Monetary Fund (IMF), accounts for about 16% of global output. China’s response to the outbreak has been a broad quarantine in impacted areas, effectively shutting down commerce. This will invariably impact global supply chains and reverberate in ways we may not fully anticipate. Both Apple and Microsoft have issued guidance for lower expected earnings this quarter. More are likely to follow. Cruise lines, airlines, and hospitality are all expected to report lower earnings as potential travelers opt to stay home. The long-term impact is unclear, but a squeeze on corporate earnings in the short run is inevitable.
The US has a small number of confirmed cases. The CDC is warning of more but said they expect Coronavirus disruptions in the US to be minimal. A literal ocean of distance and strict travel restrictions make that statement plausible. Nevertheless, investors seem content to sell risk assets in favor or safe- haven assets, such as government bonds. The flock to treasuries has pushed down yields and sent the 10-year and 30-year treasuries to record lows. Additional Fed rate cuts now look like an eventuality and point to potentially slower growth in the future.
Is the Coronavirus the sole destructive force behind the recent stock market woes? Probably not. The market has maintained bubble-like status since the beginning of the year, with nearly all technical indicators pointing to a hot and overbought market. Covid-19 may just be the catalyst for reassessment. Valuations on US equities are coming down from all-time highs and are moving closer to their long-term historic averages. It’s likely to be a few more months before the Coronavirus works itself all the way through global markets, but at this juncture we don’t believe this will be enough to push us into recession after 11 years of growth. Unemployment remains low, the US consumer is strong, and the Fed remains poised to intervene to help stave off a bear market.
This is a rapidly unfolding event and markets are whipsawing on even the slightest news. This is stressful but isn’t in and of itself a cause for major concern; markets are notoriously volatile in the short run when trying to price in the unknown. Earnings and trade will be key to whether 2020 is a boom or bust year. Last year saw an incredible run up in stock prices as the Fed lowered interest rates to buoy the economy, but earnings didn’t keep pace. Although the Coronavirus will dominate headlines this year, it will be earnings and developments on the trade front that dictate performance.
Remember, diversification helps to minimize the drawdown. Bonds are trading higher as interest rates fall. Concerns about the downside are justified, but this isn’t the time to abandon ship and deviate from long-term allocations. Equities are converging back to justifiable valuations as the world waits for Covid-19 to play out.