THE CORONA MARKET CONUNDRUM

4 April 2020

The global spread of the COVID-19 or “coronavirus” has provoked a panic in financial markets not seen since the global financial crisis of 2008. The breadth and depth of this pandemic could not possibly have been envisaged as recently as a month ago. While we have experienced viral outbreaks before such as SARS, MERS, Ebola, avian bird flu and the H1N1 swine flu, nothing before has spilled over more pervasively into the global economy. While these previous outbreaks did provoke some market reaction, the effect was relatively short lived, as containment measures were effective.

When news first broke from Wuhan in China about the emergence of a new strain of virus, the markets drew on its most recent experience with SARS in 2003 – a not dissimilar strain of respiratory coronavirus. SARS had a mortality rate of up to ten times greater than COVID-19 but was nowhere near as infectious and hence isolation and containment measures were more effective.

An unprecedented market event

The unique characteristic of the current financial market crisis is that it originated as a medical issue that has spilled over to the global economy and subsequently to financial markets. Other significant market events such as the GFC in 2008, the dot com bust in the early 2000’s, and the great market crash in October 1987 were the consequence of financial or economic imbalances that led to severe market corrections.

Given this is at its core is a health crisis, the ultimate resolution will be a medical remedy such as a vaccine or treatment drugs for infected patients. Medical opinion seems to indicate that a clinically tested and approved vaccine in normal circumstances will take up to 18 months. However, given an urgent and coordinated response from the world’s leading experts, it is conceivable this lead time could be cut to 12 months. In addition to this, over time as more people are exposed to and recover from the virus, a natural “herd immunity” is developed which limits the spread of the disease. So essentially, markets are grappling with how to value financial assets in the intervening period, whilst speculating on the eventual state of the global economy.

We are currently witnessing anything but an orderly market, with volatility on a scale that has rarely been seen before – a product of the uncertainly over the depth of the economic decline, the impact on corporate profits together with the shape and duration of the recovery. Equity markets around the world have fallen in the order of 35% from the peak of mid-February, while safe haven assets such as government bonds have been keenly sought, rising in price.

There is no question that the global economy is now in a deep recession, but uniquely, this is a recession that has been deliberately engineered by policy makers in an attempt to slow the pace of infection. In order to limit fatalities by not overburdening critical care facilities in the hospital system, protecting those at greatest risk such as the elderly. “Flatten the curve” has been the popular catch cry to define this policy.

At some point, the economy will be revived by removing the barriers currently restraining demand, the question that markets are grappling with is how quickly things will recover after this point.

Policy makers stuck between a rock and a hard place

The dilemma for policy makers is that they are faced with the unpalatable trade-off between preserving the health and wellbeing of the most vulnerable elements of society and protecting the economy. In the short term, the protection of human life is quite rightly the priority which has seen drastic measures undertaken to limit the mobility and aggregation of people, including the most recent stay at home orders for everyone except those in essential services.

In order to backstop the financial strain on individuals and businesses, an elaborate range of financial support measures have been announced. In addition to this, central banks have implemented extensive interest rate cuts and unprecedented quantitative easing measures to maintain the flow of liquidity in the banking system. The US has just announced an “open ended” QE program to inject up to $4 trillion into the financial system which will double the size of its balance sheet and include the purchase of corporate bonds for the first time. In this regard, the learnings from the GFC have been particularly helpful.

While these initiatives are usually targeted at stimulating demand, in this instance they are directed to preserving the solvency of the financial system until such time as the demand restrictions can be lifted. The quandary facing markets is that the longer these restrictions remain in place, the greater will be the damage to the economy and employment in particular. For example, in the US, the Federal Reserve estimates that unemployment may rise from a record low of 3.5% to a staggering 30% in the June quarter. These are levels not seen since the Great Depression in 1929. GDP is expected fall to an annualised minus 20-30% in the same quarter.

The risk is that in a protracted shut down, segments of the economy such as small to medium sized businesses may be permanently impaired as the government’s financial support may not be large enough or timely enough to save them. This will limit the degree to which the economy can bounce back once current restrictions are lifted. In addition to this, the sheer financial cost of the support measures will hang a millstone of debt around the neck of governments for years to come. In Australia, it took 12 years to return the Federal budget to balance following years of deficits since the GFC. Taking into account just the stimulus measures announced to date (which will likely be enhanced) the deficit will balloon to 10% of GDP. The consequences of this in future years will be higher taxes, reduced government spending and lower rates of growth.

The challenge for policy makers is to strike the appropriate balance between two conflicting alternatives. On the one hand, if the medical experts had their way, everyone would be in self-isolation for 12 months until a vaccine was available in which case the economy would be permanently destroyed. On the other hand, if the economists had their way, there would be no restrictions imposed, the health care system would be overburdened and mortality rates would be unacceptably high.

From a practical standpoint, we believe severe containment measures can only reasonably be sustained for a few months, beyond which there will permanent damage to the economy which will in turn precipitate a raft of other social costs. It’s worth noting that high levels of unemployment and business failures also bring its own set of adverse social circumstances including mental health issues, suicide, drug and alcohol dependencies, domestic violence and family disharmony.

During the time of shutdown, the imperative is to urgently ramp up the supply of critical care equipment such as respirators, testing kits and protective equipment and expand care facilities using innovative methods such as the conversion of hotels and serviced apartments for less critical cases. In this way, in addition to “flattening the curve” it can also raise “the dotted line” representing health care capacity. The manner in which policy makers strike this balance will be critical to determining both the health of society and shape of the economic recovery.

Investment Outlook

It is quite possible that there may be further downside in equity markets, however the temptation to sell down now after such a steep decline and buy back at lower levels is fraught with difficulty. With market sentiment so fickle and volatility so high, sentiment can turn on a dime with positive news on stimulus measures, declining rates of infection or progress on vaccines or treatment drugs.

While our multi-asset portfolios have certainly felt the brunt of the market sell off, at the outset of this event we were conservatively invested in a portfolio of high quality Australian and international companies that are well placed to recover their value in time. In recent months, we also added Australian government bonds and US Treasuries which, together with a healthy US dollar exposure have provided some valuable downside protection.

It is important to note that we deliberately avoid “alternative” investments, many of which will now move to limit redemptions, impose exorbitant exit fees while severely writing down their asset values. We construct portfolios using securities that are priced and traded in public and over the counter markets. This provides complete transparency with no added layers of fees, a daily portfolio valuation and liquidity if required.

For investors that are not forced to sell assets, staying the course and sticking to your long-term strategy is the soundest plan of action to ultimately restore portfolio value. In closing, it’s worth reflecting on the fact that in all three of the major market downturns noted earlier, markets eventually recovered and went on to post new highs. We have every reason to expect that in time, this will be case here as well.