2020 began with global markets for stocks and other risky assets priced for Global equity markets woke up to the economic risks posed by the coronavirus outbreak, with the S&P 500 declining over 10% from its peak through yesterday. Foreign stocks fared slightly better with the MSCI EAFE Index, which primarily reflects Europe and Japan, returning -6.7% and emerging markets returning -4.9%. Energy, transportation and hospitality stocks have suffered the worst impact. As of February 27, the S&P 500 was down 7.5% year-to-date. However, given the strong performance in 2019, the one year return remains a positive 9.1%.
As we mentioned in our January 31 update on the outbreak, a prolonged pandemic could be a catalyst for a global recession. This would require continued supply chain disruption, a drop in consumer spending and accompanying corporate financial distress sufficient to spark a self-sustaining vicious spiral of defaults, layoffs and further reduced consumer and corporate spending. Natural disasters such as hurricanes or earthquakes do not generally cause prolonged economic downturns, nor have past pandemics such as the 2003 SARS outbreak. In these cases, a short-lived interruption in economic activity is quickly followed by a resumption of normality. However, the virulence of SARS-CoV- 2 (the official name of the coronavirus) and the several week length of the illness makes for a potentially greater impact on economic activity.
This outbreak comes at a particularly vulnerable time, with stocks trading at expensive valuations based on expectations of strong earnings growth. Corporate debt levels, both in the US and China, are also at historic peaks. Alternate, real- time measures of Chinese economic activity – including electricity generation, traffic congestion and ship traffic – reveal that the country’s economy remains at a near standstill. Apple and Microsoft both warned of supply interruptions negatively impacting earnings this quarter. It remains to be seen whether this will be a temporary blip or a trigger for a more prolonged downturn.
Attempting to time an exit and re-entry point to sidestep these risks remains a fool’s game. Stocks offer higher returns than bonds because their values decline during periods of uncertainty and economic weakness. This volatility is much greater than the actual volatility in corporate earnings and dividends, particularly for the higher quality companies on which our managers focus. Markets anticipate future events and discount probable outcomes. Ultimately, the risk of destroying value through an ill-timed exit and re-entry into stocks outweighs the risk from simply staying put.
The health risks to individuals in the US remain small. COVID-19 fatalities are concentrated on older individuals with pre-existing conditions, much like the flu. Mortality rates for people below 50 and/or those with no pre-existing conditions are well below 2% and nearly 0% for people below the age of 40. While isolated cases have been found in the US, there remains no evidence of a sustained contagion.
As mentioned in our January update, last year we reviewed portfolios to ensure adequate reserves of safe liquid assets to meet several years of distribution needs. While our focus on owning quality businesses and avoiding balance sheet risks does not protect from short-term volatility, it does protect against long-term impairment or destruction of capital. While the extent of the fallout from the virus-induced slowdown in China and disruption of global supply chains and consumer spending remains uncertain, it does not warrant changes to current portfolio strategy or targets. As we review portfolios, we will look to bond portfolios, which have risen in value as rates dropped to record lows, as a source of liquidity for distribution needs, and we will prioritize maintaining an adequate liquidity reserve over rebalancing from bond portfolios into stocks and other risky assets.