Key Points:

• Financial market volatility has picked up due to concerns that the new coronavirus is more widespread than was initially thought and that it could affect more economies than just China.

• Investors have responded quickly to heightened uncertainty about the potential effects of the coronavirus outbreak by selling out of riskier assets in favor of safe-haven assets. Economists and investors have lowered their expectations for global economic growth, industrial commodity demand, and corporate earnings growth.

• Historically, markets and economic activity have tended to level off and then begin to rebound once the rate of confirmed virus cases stops rising, so we believe that will be a key factor to watch in the near-term.

• Investors need to pay attention to news about global virus outbreaks. However, we believe that markets have overreacted about the coronavirus and will likely continue to overreact as new developments surface.

• During times of heightened market volatility and fear, it may seem like a logical approach to try to “time the market” by getting out when markets conditions get bad and buying back in later on. However, in practice, timing the market is tough to get right more times than not, and can often result in missing out on significant returns during recovery periods.

What is the current situation?

News about the coronavirus broke out in January, but up until recently, market sentiment has been mostly positive on the hope that health officials would be able to contain the epidemic, resulting in only a short-term disruption to growth.

Recently however, financial market volatility has picked up due to concerns that the new coronavirus is more widespread than was initially thought and that it could affect more economies than just China. The virus has recently spread to other parts of the world, including Italy, South Korea, Iran, and other countries. Meanwhile, in the U.S., the Centers for Disease Control and Prevention expects a wider spread of the coronavirus domestically.

On the positive side, the World Health Organization (WHO) has confirmed that new cases are on the decline in China after the epidemic peaked between January 23rd and February 2nd. The World Health Organization (WHO) has also recently said the outbreak doesn’t currently qualify as a pandemic. Similarly, the CDC has not definitively said that there will be a pandemic in the U.S., but rather they want to start preparing for that potential scenario as they remain unsure about how severe the health threat could be.

What has been the impact on financial markets?

Investors have responded quickly to heightened uncertainty about the potential effects of the coronavirus outbreak on China and the global economy by selling out of riskier assets in favor of safe-haven assets.

Price declines have been most significant in risk-based assets exposed to China and travel, including stocks in China, stocks in Asia most directly exposed to China, airline stocks, copper, crude oil as well as energy stocks.

On the other hand, safe-haven assets have appreciated in value, including global government bonds, municipal bonds, investment-grade corporate bonds, and securitized bonds. Interest rates have dropped to new lows on concerns the outbreak could widen further and stifle global growth.

How is the economy likely to be impacted?

In light of the recent coronavirus outbreak centered in China, where manufacturing, consumption, and travel stood still in February, economists and investors have lowered their expectations on global economic growth, industrial commodity demand, and corporate earnings growth.

Due to China’s integral part in the global economy—accounting for roughly 18% of global economic activity, including 31% of manufacturing, 12% of exports, and 18% of travel spending—Vanguard economists estimate that the virus could slow 2020 global economic growth by 0.15 percentage point.¹ To put this in perspective, the global economy grew 3.0% in 2019, and prior to the coronavirus outbreak, was projected to grow by 3.4% in 2020.²

Given what is known at this point, China and other emerging market countries in Asia are likely to be hit the hardest from an economic perspective. Vanguard economists estimate that the virus could take about 0.5 percentage point of growth from China's economy this year.¹ China’s economy grew 6.1% in 2019, and prior to the coronavirus outbreak, was projected to grow by 5.8% in 2020.²

Meanwhile in the U.S., the economic effects of the coronavirus on the economy are still expected to be modest. This is despite the fact that the U.S. is the largest destination for Chinese exports (by dollar value)³ and that certain U.S. industries could be severely impacted by extended disruptions in supplies from China. Vanguard economists estimate only 0.1 percentage point in lost or delayed U.S. economic activity.¹ The U.S. economy grew 2.4% in 2019 and was projected to grow by 2.1% in 2020.²

It’s important to keep in mind that lack of certainty about how far the coronavirus will spread makes economic projections particularly challenging. The forecasts mentioned above assume that the virus will stay primarily contained in China, but if it spreads more widely, particularly in the U.S. and Europe, a bigger global slowdown could occur.

Historically, the pattern around virus outbreaks has been a temporary drop in economic growth—concentrated in affected countries—followed by a rebound in the following quarters as pent-up demand spurs economic activity again. We have no reason to believe that history will not repeat itself particularly as governments today appear ready to take necessary steps to stop the virus and stimulate faster growth if necessary. Regardless, the net outcome will likely not become clear for at least several months.

Over the longer term, we hold our view that the global growth slowdown that started in late-2018 has likely neared a bottom, and the risk of a major global recession is still relatively low. Continued central bank stimulus will likely stave off a global recession and eventually result in a pickup in economic activity once again.

What is the outlook for financial markets?

We expect coronavirus-based volatility to be intermittent, and it will likely be around for some time. With little clarity on the severity of the epidemic, as well as uncertainty about if officials will be able to effectively contain it, this issue will likely contribute significantly to market volatility. On top of coronavirus concerns, markets still face a myriad of global geopolitical issues and the U.S. presidential election, which will likely cause investor sentiment to swing more widely than usual in 2020.

The epidemic is expected to weigh on global supply chains and pressure corporate earnings, notably for automakers, technology end-product providers, and clothing retailers. Looking ahead, the potential hit to retail sales and tourism could hurt stocks in the consumer discretionary sector, notably the hotels, restaurants, and leisure industries.

Historically, markets have tended to level off and then begin to rebound once the rate of confirmed virus cases has stopped rising. Thus, we believe that this will be a key factor to watch in the near-term. The situation today is very reminiscent of the SARS outbreak that hit China in 2002 and 2003, although structure of the global economy was significantly different than today. The number of reported SARS cases soared in the spring of 2003, during which the global stock market fell over 14%.⁴ As the number of reported SARS cases slowed in late spring, the global stock market fully recovered its losses in less than two months and ultimately finished the year rising over 43% from the low point.⁴

At this time, we still believe that the current environment for stocks is generally favorable. Given relatively easy financial conditions (i.e., lower interest rates) and a healthy economic backdrop, corporate earnings should still accelerate in 2020. As such, positive stock returns are expected; gains, however, are likely to be subdued this year, especially in comparison to last year.

Similarly, bond returns are expected to be positive but lower than last year, given that interest rates are expected to remain low throughout 2020, likely even lower than what was forecasted prior to the coronavirus outbreak. Regardless, high-quality bonds will continue to be essential diversifiers in a portfolio, as they have been so far this year during the coronavirus scare.

What should investors do?

Investors need to pay attention to news about global virus outbreaks. However, we believe that markets have overreacted about the coronavirus and will likely continue to overreact as new developments surface. Market overreaction is partially due to the speed and abundance of information that has emerged about the virus—some accurate and some not—and partially because markets have been so strong recently without a major correction (a decline of 10% or more) since late-2018.

Investors that have properly balanced and diversified portfolios should not worry excessively about stock market volatility. The recent declines are a natural part of the stock market and are why stocks typically generate higher returns over long periods of time than more conservative investments like bonds. Nevertheless, the recent market declines prove that bonds serve an essential purpose in a balanced portfolio.

Having “balance” in a portfolio means having an appropriate amount of high-quality bonds to complement stocks. This balance can help investors ride the stock market wave up and down, without eventually feeling the need to get out of the market just so they can sleep at night. High-quality bonds have been a strong ballast in portfolios so far this year and should continue to provide support during future bouts of market volatility.

Being “diversified” means spreading out your investments within both stocks and bonds, so that there isn’t concentration in any one sector like energy and consumer discretionary, or in any one country like China or other inherently volatile emerging markets. However, being diversified doesn’t mean an investor’s portfolio shouldn’t hold these types of investments or that they should sell them because they are down a lot. Rather, diversification helps ensure that a portfolio is positioned to capture returns wherever they occur, and of course, to mitigate the risk of any one sector or country selling off.

Why investors should avoid market timing?

One of the principals of our philosophy is that most investors should stay invested for as long as possible. Our philosophy is contrary to an approach that suggests that one should try to “time the market” by getting out when markets conditions get bad and buying back in later on. Although timing the market sounds logical, in practice, it is tough to get right more times than not. Often, it can result in missing out on significant returns during recovery periods.

Market timing is not an enduring investment strategy. Instead, the enduring strategy is to stay invested in a properly balanced and diversified portfolio and implementing a disciplined investment process. Sticking to one’s investment plan during times like this can increase the chances of achieving investment success and substantially growing wealth over time.

We continue to monitor developments about the spread of the coronavirus and its impact on markets and global economy. We also 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 areas of the market hit hardest by the coronavirus outbreak.

Sources:

¹Vanguard: https://advisors.vanguard.com/insights/article/coronavirustollincludestensofbillionsinlostgrowth  

²International Monetary Fund: https://www.imf.org/en/Publications/WEO/Issues/2019/10/01/world-economic-outlook-october-2019

³World’s Top Exports: http://www.worldstopexports.com/chinas-top-import-partners/

⁴YCharts, MSCI: Global stocks as measured by the MSCI ACWI Index, fell -14.3% from 1/14/03 to 03/12/03 and gained +46.53% from 03/12/03 to 12/31/03.

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.