Coronavirus outbreak: Our perspectives on the global market selloff
Key Points:
Financial market volatility has reached levels not seen since the global financial crises in 2008. The severe market turmoil has been due to concerns about the significant drop in business activity and global trade from escalating efforts by public-health authorities worldwide to contain the coronavirus outbreak.
It is important to remember that the crisis in 2008 was one in which the financial lending markets froze, which led to a collapse of the global financial system. Today, the world’s financial system is less fragile than it was during the 2008 financial crisis, which should help limit the consequences of recent extreme market moves.
The Federal Reserve (the Fed) has already started to take the appropriate actions to help lessen the economic blow of the spreading virus as well as to ensure that the financial system is functioning properly. In addition to supportive monetary policies, governments are likely to implement fiscal policies to support their economies.
In the midst of a virus outbreak, it is easy to focus on all the negative impacts on the economy and markets with the constant news flow. However, there are several things to point to that could help the global economy and financial markets quickly get back on track.
Over the past two years, we have made several changes to client portfolios to better endure short-term market volatility and improve long-term returns. These portfolio management changes should continue to serve our client portfolios well.
We continue to regularly monitor client portfolios to ensure that they stay close to their target mix based on client-specific objectives. Our portfolio trading team is actively looking at portfolios to identify opportunities to rebalance by trimming from bonds that have appreciated and adding to stocks at significantly discounted valuations.
Given the elevated risks and uncertainty today, stock markets could fall significantly more from here. While we would never try to time the markets, we certainly have some other action plans that we could put in place to further alleviate portfolios from a worst-case, extreme, scenario.
What is the current situation?
Financial market volatility has reached levels not seen since the global financial crises in 2008. The severe market turmoil has been due to concerns about the significant drop in business activity and global trade from escalating efforts by public-health authorities worldwide to contain the coronavirus outbreak. Although infectious disease specialists have been warning about an emerging pandemic in various countries outside of China, including the U.S., markets continue to be surprised about the ever-increasing number of confirmed cases around the world.
U.S. stocks recently suffered their worst day since 2008, falling over 7% as an oil price war between Saudi Arabia and Russia added to heightened investor concerns about stalling economic growth. The disagreement between Saudi Arabia and Russia over oil output drove a fall in oil prices by as much as 30%. The dramatic fall in oil prices has raised fresh concerns about the risks tied to heavily indebted energy companies and the banks that have lent to them. Investors are worried that the default risk will lead to tighter lending conditions and even a recession.
Many stock-markets around the world have already entered a bear market, defined as a 20% drop from a recent high. The U.S. stock market is close to entering a bear market, which last happened during the global financial crisis more than a decade ago. On the other hand, investment-grade bond markets have risen significantly as investors have fled to safe-haven assets. Interest rates have continued dropping to record lows.
How does this compare to the 2008 financial crisis?
The magnitude and speed of the recent stock market declines have many media outlets comparing this to the 2008 global financial crisis. It is important to remember that the crisis in 2008 was one in which the financial lending markets froze, which led to a collapse of the global financial system. Based on our recent discussion with some of the world’s largest asset managers, including Vanguard, BlackRock, Capital Group, JPMorgan and Goldman Sachs, none of them are predicting a financial system collapse. Despite the extreme volatility, financial markets are functioning well.
The fact of the matter is that the world’s financial system is less fragile today than it was during the 2008 financial crisis, which should help limit the consequences of recent extreme market moves. The world’s major banking institutions are far better able to weather shocks than they were in 2008, and the underlying plumbing that keeps markets moving has yet to show the signs of seizure that characterized the global financial crisis. Large banks are less than half as leveraged as they were in 2008, according to the Financial Stability Board.
We think it is very unlikely that we’re going to see the sort of economic ramifications as we saw from the global financial crisis. This unfortunate spreading of disease is different from the global financial crisis, where there was massive deleveraging of housing that really left a long period of job losses. The 2008 crisis was essentially a situation where the financial system imploded, and the subsequent recovery took several years. Better defenses against a similar outcome today should assuage some of the worst fears in markets right now.
What can be done to alleviate financial market turmoil?
The Federal Reserve (the Fed) has already started to take the appropriate actions to help lessen the economic blow of the spreading virus as well as to ensure that the financial system is functioning properly. Steps taken so far have included cutting short-term interest rates by 0.50% to 1-to-1.25% range and responding to any signs of lock-up in the lending markets by providing liquidity. International central banks have also indicated that they are ready to implement coordinated stimulus efforts.
The Fed could take other measures to ease financial conditions, including further lowering of the Fed funds rate to the near-zero level, implementing on new types of quantitative easing, and providing more liquidity to the banking system. The Fed could also establish a variety of special-purpose programs to support the financial system, but we’re not close to that.
In addition to supportive monetary policies, governments can implement fiscal policies to support their economies. So far in the U.S. there hasn’t been anything significant on that front other than the $8 billion appropriation for the Coronavirus funding. However, if economic conditions get materially worse, we could see other fiscal stimulus packages including tax breaks for individuals and corporations and other forms of financial relief.
What is the outlook for financial markets?
We acknowledge that risks are high at the moment, and that it is hard to predict the turning point of both the economy and markets. We also acknowledge that things will be uncomfortable in terms of volatility and returns for a while longer. While we can’t predict the future, we can always look back historically to how often market downturns occur and what happened after. (See Figure 1.) Market downturns are inevitable, but markets have always bounced back from crises in the past.
In the midst of a virus outbreak, it is easy to focus on all the negative impacts on the economy and markets with the constant news flow. We acknowledge that the virus and the global reaction to prevent its spread has slowed economic activity and caused supply chain disruptions around the world. It is doing damage to business and consumer confidence that will likely result in significant business pull back on hiring and investments, and less consumer spending. The economy could very likely enter into a mild and short-lived recession.
However, there are several things to point to that could help the global economy and financial markets quickly get back on track. Interest rates around the world are at record lows and are likely to go lower, which should help to stimulate lending. Oil prices are near record lows, which should help boost demand and disposable income for consumers. Stock market valuations are no longer expensive. Heading into the year, the global economy (particularly the U.S.) was starting to show significant signs of strength, particularly on the job and housing fronts. And last but not least, we are beginning to see a resumption in activity in China, which should limit further disruption in U.S. supply chains.
Once the number of cases globally starts to crest, the financial markets will likely start to look at that and then quickly move on. There is some reason for hope given that the number of confirmed cases in mainland China has plateaued. (See Figure 2.) The problem is that cases outside mainland China have only recently begun to accelerate—with expectations of significant jumps to come in the United States once testing can be done more widely.
What has been done to help protect my portfolio for situations like this?
Over the past two years, we have made several changes to client portfolios to better endure short-term market volatility and improve long-term returns.
One significant change was to reduce portfolio exposure to riskier bonds. In essence, this means that we removed bonds that are issued by weaker companies that would have a higher probability of default should the economy and market conditions deteriorate. These lower-quality bonds were replaced by higher-quality bonds, issued by government, municipalities, and financially stronger companies. This shift has worked out well, particularly during volatile market conditions, as these typed of bonds have helped to cushion portfolio losses.
Together with reducing bond credit risk, we increased portfolio exposure to longer-term maturity bonds. We made this shift not only because longer-term bonds reward investors with higher returns over time, but more importantly, because they appreciate more than shorter-term bonds when stock market volatility increases. This shift has worked out well recently, as these types of bonds have helped to offset stock losses and have provided more opportunity to rebalance portfolios by buying stocks at cheaper valuations.
Another significant change was to minimize individual stock, sector, and industry concentration by further diversifying stock allocations globally across thousands of companies. This has helped to limit large potential losses from any one particular stock, sector, or industry. It has also helped to capture market appreciation by remaining broadly diversified across most areas of the market.
Together with minimizing any stock market concentrations, we added allocations to real estate and infrastructure. These types of companies own and operate high-quality commercial real estate and essential service infrastructure. These physical assets typically generate relatively high and consistent cash flow, supported by steady demand and long-term contracts. As a result, real estate and infrastructure companies tend to pay out relatively higher dividends and have had defensive characteristics, particularly during the recent bouts of market volatility.
These portfolio management changes should continue to serve our client portfolios well. Many investors may think high-quality bonds, particularly Treasury bonds, cannot move further after having already made such large moves. However, we would argue that the safest government bonds have been the only consistent source of insurance against the current selloff, and will likely continue to offer protection if things get worse.
What is Capstone doing now?
We continue to monitor developments about the spread of the coronavirus and its impact on markets and the global economy. We are also monitoring the current situation in the oil market and the potential knock-on effects.
We continue to regularly monitor client portfolios to ensure that they stay close to their target mix based on client-specific objectives. Portfolios have performed in line with our expectations amid recent market volatility, and have thus far not been materially impacted by specific areas of the market hit hardest by the coronavirus outbreak or the oil price war.
The downside volatility we’ve experienced in stock markets has coincided with significant gains in high-quality bonds. Our portfolio trading team is actively looking at portfolios to identify opportunities to rebalance by trimming from bonds that have appreciated and adding to stocks at significantly discounted valuations. Coinciding with these rebalance trades, the team is looking at opportunities to harvest losses in stocks to offset future portfolio gains and lower client tax bills.
What could Capstone do if market conditions get materially worse?
Given the elevated risks and uncertainty today, stock markets could fall significantly more from here. While we would never try to time the markets, we certainly have some other action plans that we could put in place to further alleviate portfolios from a worst-case, extreme, scenario.
One aspect of risk mitigation could be portfolio management action plans that could include widening our rebalance bands to effectively lower the rebalancing frequency into stocks. This would help to mitigate further losses should stocks continue to decline significantly. Another portfolio management action plan could be to raise cash for any needed portfolio withdrawals by trimming only from the bond side of the portfolio; this would help to mitigate the risk of selling stocks low and locking in losses.
Another aspect of risk mitigation could be portfolio asset allocation action plans that could include adding more defensive-oriented stock strategies to the portfolio or shifting some of the international stock allocations to U.S. markets. These moves would also help to mitigate further losses should stock continue to decline significantly.
At this time, we don’t believe that these action plans are necessary. However, should market conditions materially deteriorate, we will not hesitate to execute these plans. Our clients should rest assured that any decisions we make when it comes to portfolio management are deliberate and executed with discipline. We urge investors not to panic and stick to their long-term investment plans. We will continue to keep clients apprised of the evolving situation. Please do not hesitate to reach out to us should you have any questions or concerns. As always, we will be here for you.
Important Disclosure Information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by Capstone Financial Advisors, Inc. (“Capstone”) will be profitable. Definitions of any indices listed herein are available upon request. Please contact Capstone if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Investment decisions should always be based on the investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.