2nd March 2020
Firstly, please bear in mind that we are writing this briefing from an investment point of view and all at HFP are completely sympathetic to all families affected by the virus.
As an investor (either new or experienced) there are some very important terms to either be reminded of or learn afresh.
At present, as we are writing this, we are in Correction territory!
Our emotions should not be stirred by a correction and only occasionally by a bear market. That is because the two phenomena are frequent occurrences and happen more often than we recall.
Corrections are particularly common. They have, on average, occurred every 12, 18 or 24 months. Bear markets are less common, and they’ve hit as often as three times during each decade. If you're a long-term investor, and virtually all our clients are, you’re going to see several corrections and more than the odd bear market.
Despite each decline, as frequent as they are, the stock market generally provides investors with returns which are commensurate with the risks involved. Indeed, action which is intended to avoid losses during periods of stock market decline, like ‘selling out’ into cash, more-often-than-not detract from the returns a passive approach (i.e. not selling out!) can more easily capture.
If you are tempted (and it is very easy to be when you see the week we have just experienced) to sell out of the market, or to move into a lower risk position, ask yourself this; if that portfolio was previously judged to be appropriate given a reasonable analysis of objectives, preferences and timeframe what has changed? Is the future any more certain today? The stock market may decline further from here or it may not.
With that uncertainty in mind, we will admit that we don’t know if what we have experienced recently will prove, with hindsight, to be a correction, a bear market or something more severe.
Our guess is that the stock market’s fortunes will be reversed before we move beyond a bear market and our reasons are twofold.
First, our reading of the situation as reported by the World Health Organisation (WHO) is one of cautious optimism. Remarks made by the WHO’s Director General on 26th February suggest that the epidemic inside of China ‘peaked and plateaued between the 23rd January and the 2nd February and has been declining since then’.
Furthermore, there has been ‘no significant change on the genetic makeup of the virus’. Outside of China, it is true that ‘sudden increases in cases in Italy, the Islamic Republic of Iran and the Republic of Korea are deeply concerning’ but that is balanced by better, but less widely reported news. For instance, ‘14 countries that have had cases have not reported a case for more than a week and even more importantly, 9 countries have not reported a case for more than two weeks’.
Remember also, we have seen previous outbreaks of health scares such as SARS, Ebola, MERS and Zika. Given its Chinese origins, the SARS outbreak in 2003 is the best comparison, although circumstances are very different today. Back in 2003, China’s share of the global economy was just 4% but today it is almost 16%. Additionally, stock market valuations around the world are higher and we are at a later stage of a more mature economic cycle.
The WHO, incidentally, is critical of those politicians pushing for a pandemic to be declared…
‘Using the word pandemic carelessly has no tangible benefit but it does have significant risk in terms of amplifying unnecessary and unjustified fear and stigma, and paralyzing systems. It may also signal that we can no longer contain the virus, which is not true. We are in a fight that can be won if we do the right things. For the moment, we are not witnessing sustained and intensive community transmission of this virus and we are not witnessing large-scale severe disease or death’.
Countries are taking extraordinary steps to contain the virus and pharmaceutical companies around the world are working towards a vaccine at a record pace.
The second reason for our less apocalyptic outlook is that the market for commodities and for bonds is already offering a kind of stimulus which will act to underpin global economic output. Oil prices are down 10 percent in the last week or so. A further boost is provided by lower long-term interest rates in the US, UK, eurozone and Japan. Indeed, as we approach steeper stock market declines, there is a rising likelihood that the big four central banks will weigh in with monetary support too.
To illustrate this point, the bond market in the UK is priced for a 31 percent chance of a 0.25% rate reduction (to the Bank of England base rate) in March when the Monetary Policy Committee next meets. One week ago, the same prospect was priced at less than 6 percent.
A similar picture has emerged in the US. One week ago, the odds of a rate cut at the next meeting of the Federal Open Market Committee in mid-March was priced at around 9 percent. Today, the bond market prices the same event at 63 percent.
Rightly or wrongly, we are minded to view current conditions in constructive terms.
Outside of the UK (and except for Germany), equity market valuations have been thoroughly unappealing and with uncertainty comes opportunity. Prior to today, the most appealing prices could be found in London and it’s not difficult to see why. There have been years of worry accumulated following the 2016 EU referendum and culminating last December in the potential for a hung parliament or a more severe political environment. While the UK rouses from its slumber, with a strong majority government, the UK now looks very appealing.
In fact, now that we are in correction territory, we see opportunities elsewhere too and particularly in the US.
More recently we have viewed the US market with mixed feelings. On the one hand, US equity market valuations have been horribly elevated but on the other, nominal rates of economic output growth have been sustained in the 4.0 percent to 5.0 percent range that we consider to be something of a sweet spot for stock market investment.
Assuming the coronavirus remains largely contained and that the resulting economic slowdown proves temporary, investors have an opportunity to buy into US stocks at discounted levels. Lower prices are allied with the promise that economic growth will trend back above the 4.0 percent threshold and that is very attractive.
It is important to remember that global consumption has not disappeared, but it has merely been postponed.
With any sensible portfolio planning you should aim to have a well-diversified portfolio of bonds and equities to reduce the concerns of short-term fluctuations in the stock market. Stock market prices often rise, and they often fall, and we don’t know in advance when a bear market might strike but we do know one will happen at some stage.
Today, while the headlines obsess with declining stock prices, little is being said of surging prices in the market for US treasuries, gilts and bunds.
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