Benjamin J. Michaud, CFA In the few days since our recent note on the Coronavirus situation, the headlines and corresponding market volatility have notably worsened. Obviously, the actions being taken to contain the virus are likely to take a measurable economic toll. The disruption of global supply chains and changes in consumer behavior raise the odds of a global recession, which is being factored into stock valuations as we speak. This morning’s 7% decline at the market’s open brought the decline from the February highs to 18% – a meaningful correction by any definition.
Given our highly connected world and the unique nature of the threat, it should come as no surprise that the virus is spreading to all corners of the globe, including the US. To those of us who appreciate the market’s efficiency as a discounting mechanism, the rapid spread of the virus alone doesn’t explain the latest increase in volatility. The collapse in crude oil prices brought about by Russia’s unwillingness to cooperate with OPEC on production quotas also has sobering implications for resource-dependent economies in emerging markets and adds to the already high level of market uncertainty.
Although our client portfolios are not immune to the recent declines, we’re confident that the high-quality companies that populate them will weather any degree of economic duress, and our exposure to energy stocks has been limited. That said, there are portfolio measures we intend to take in response to the volatility. In taxable accounts we can harvest losses and redeploy proceeds into high-quality companies that may have been prohibitively expensive until now. The volatility also presents an opportunity to add marginal exposure to cyclical and small-capitalization stocks that have been hit hard. On the fixed income side, we will continue to keep durations short and be vigilant on credit quality.
Importantly, as we pointed out in our last note, we believe the odds of a severe or protracted recession are low; this is not 2008. Credit markets are functioning well, and liquidity is readily available – conditions that are historically not conducive to recessions. Further, we can expect additional coordinated central bank stimulus and a healthy dose of fiscal stimulus here in the US.
Volatility like this is always unsettling, but it is precisely during these times that some perspective is useful. To wit, the 22% one-day decline in 1987 is now a barely discernible blip on the chart of long-term equity returns. We cannot predict how or when the virus spread will be contained, or what the economic impact will be, but we do not expect to change our long-term approach to asset allocation and portfolio construction. As long as bonds offer zero – or negative – real returns, we remain convinced that an asset-liability matching framework, in which we set aside enough cash and/or bonds to meet several years of liquidity needs, will avoid the need to sell equities at distressed prices and protect the purchasing power of our clients’ assets over time.
