Watch Your Downside

By Victor Zhang - February 24, 2020

New coronavirus outbreaks outside China are rattling global markets. Investors who had previously taken the epidemic in stride are now coming to grips with concerns about COVID-19’s impact on global economic growth and corporate earnings.

Until recent trading sessions, the market seemed to anticipate the virus would be quickly contained. However, reports of new outbreaks have led many investors to reduce their stock exposure and gravitate toward perceived safe havens such as U.S. government bonds. This pushed U.S. Treasury yields to new lows on concerns the outbreak would widen further and stifle global growth.

We believe concern about downside protection is warranted, but investors shouldn’t deviate from their long-term strategic allocations.

Still a Lot to Learn

The new virus draws frequent comparisons to SARS, which killed 774 people worldwide in 2002 and 2003. While there are parallels, researchers still have much to learn about COVID-19. We are already aware that the new virus is more easily transmitted and more difficult to detect.

From an investment perspective, it’s important to recognize the differences in the global economic landscape between 2003 and today. At the time of the SARS outbreak, China accounted for roughly 4% of global economic output, according to the International Monetary Fund (IMF). Today, IMF data places China’s share of global output at 16%, making it the world’s second-largest economy.

Expect Disruptions

Against this uncertain backdrop, we expect the epidemic to weigh on the global supply chain and pressure corporate earnings in the near term.

Many companies that sell goods in China or whose supply chains include important links in China have already warned investors about weaker revenues and earnings. Apple is a high-profile example. The company has reduced its sales expectations because of the slow production recovery in its China-based factories and closure of its stores in China.

We expect the global travel industry will experience disproportional disruption. Companies dependent on Chinese tourists also expect to take a short-term hit. The number of outbound trips by Chinese tourists climbed from 16.6 million in 2003 to 149.7 million in 2018, according to Chinese government data. They now face travel restrictions.

Be Prepared for Continued Volatility

Today’s volatility is a sign of imperfect information. We expect continued volatility as the market digests news about the virus and attempts to assess the economic impacts. Ultimately, we believe earnings will be key to 2020 performance. Security prices rose sharply last year, but profits didn’t keep pace. This year, we need to see earnings growth that helps justify the market’s 2019 advance.

Coming into 2020, we recommended an approach that balances upside potential with your tolerance for short-term volatility. These events only reinforce our view. Position your portfolio to participate in the market’s upside with less exposure to volatility that could accompany swings in investor sentiment or jolts from unexpected economic or geopolitical events. This could mean complementing long-term growth positions with holdings in more defensive high-quality companies that have sustainable business models and a history of paying dividends. In your fixed-income portfolio, try to ensure you’re getting the risk profile you would expect from bonds by favoring sectors with less correlation to the stock and high-yield bond markets. Also consider alternative investments, which offer the potential of reducing downside risk.