27 February 2020

    The pendulum has swung

    Share markets wake up to the coronavirus

    We first shared our thoughts about the coronavirus outbreak on February 5 highlighting that share markets, in particular, were pricing in a swift resolution to the epidemic. With so much uncertainty, and a wide range of possible outcomes, we felt the market was not placing enough weight on a more sustained outbreak. Caution, in our view, was warranted.

    Unfortunately we were right to be cautious. Since then the virus has spread more widely, the human toll has grown and concerns about the economic impact get bigger by the day. Where the share market was blithely ignoring coronavirus, it is now front and centre of everyone’s attention. Fear, not complacency, is gripping the market.

    What we have been doing in portfolios?

    As the coronavirus epidemic unfolded share markets seemed surprisingly complacent about the very real, possibility of the virus spreading more widely.

    We felt more caution was warranted. That meant, where we have discretion, we have less invested in international and New Zealand shares than is usual.  That helps protect portfolios and provides flexibility to purchase shares in our favoured companies as prices fall.

    Fixed income is an important portfolio insurance policy in difficult environments. As the coronavirus outbreak first struck we added to our high quality international bond exposure in multi-asset funds and, within fixed income specific funds, we increased exposure to longer maturity government bonds. This both protects portfolios and is a source of gains as government bond values typically rise on the back of economic weakness.

    Finally, we have less exposure to the New Zealand dollar than is typical. With the New Zealand economy being small and dependant on trade the Kiwi dollar has historically been a poor performer when global risk rises.

    Despite the market sell-off in recent days we believe this caution is still warranted.

    A growing human and economic toll

    Going into 2020 economic data around the globe had been improving supported by accommodative monetary policy. Coronavirus has made that data about as relevant as last month’s newspaper.

    Widely publicised supply chain disruptions for companies like Apple, the cancellation of all manner of events and travel and inevitable caution that both consumers and businesses will have to spend and invest will materially impact economic growth, at least in the short term. 

    No one really knows the extent of the medium-term economic toll although the risks are clearly growing.

    Markets are responding:  

    1. Interest rates in the United States are now at all-time lows and have fallen materially in other markets. Interest rate markets are pricing in lower economic growth and lower inflation. In a similar vein the market now expects central banks to cut short term interest rates in an effort to support the economy and to revive growth.

    2. The New Zealand dollar has fallen over 7% against the US dollar since the beginning of the year. While the Reserve Bank of New Zealand had pointed to a more balanced outlook in its last Official Cash Rate announcement, we would expect this rhetoric to change. Both a falling Kiwi and the possibility of further interest rate cuts in New Zealand are an important safety valve for our economy.

    An increasingly negative economic outlook and expectations of significant monetary policy easing have now been priced into fixed income and currency markets.

    Until February 19, when the US share market posted an all-time high, shares had somehow seemed immune to the coronavirus.

    That hides a more nuanced story. The early market strength in 2020 had been driven by a small handful of companies. For instance, only 10 stocks had been responsible for 68% of the S&P 500 return for the year. The share prices of most firms, and in particular those more sensitive to economic growth, have been lagging the market badly.

    Returns being generated by a small group of companies is not a healthy sign for the market - although the underperformance of most other companies does at least mean that some of the economic risk associated with coronavirus is being priced into share prices. This has only accelerated in recent days.

    The Pendulum has swung

    With the pendulum having swung from complacency to fear falling, share prices and lower interest rates look more appropriately priced for the risk that coronavirus presents. For investors that is a good thing.

    More generally we can now only hope that the fear that gripping markets and writing headlines proves to be overstated and that the human toll does not rise too heavily from here.

    Of course our job is not to invest on hope but to be realistic. We remain cautious but vigilant both to the risks of things getting worse but also to the opportunities that volatile markets might present.

     What this means for you

    For most of our clients, particularly if you have at least a medium-term investment horizon, overreaction to events like this typically proves to be a bigger risk than inaction. Patience and a long run perspective are critical ingredients to successfully compounding your wealth over time. For those of you looking to build your investment portfolio this looks more like an opportunity than a long run threat. Of course, if you are worried and you think it is time to revisit your investment strategy then please get in touch with our team. We are here to help.