Navigating the pandemic of fear
History was made this month with the black swan event of a Covid-19 virus outbreak, a collapse in oil prices follow by massive government and private sector responses to a novel threat on human lives.
Equity markets have now plunged about 28 per cent since touching an all-time high on February 19, officially ending an 11-year bull run.
With Covid-19, the news media found an engaging new soundbite which ultimately succeeded in handing business and government leaders marching orders to shut down, at least partially.
The result will likely be further market dislocations, price gyrations, near term loss of wealth, and thrifty savers being further punished as interest rates go back to zero. In the meantime, the pandemic of fear is spreading much faster than the virus itself, as veteran economist Ed Yardeni recently commented.
In this time of economic and market stress, it is important to evaluate the true facts and act rationally. Having lived and worked in this profession through the 1987 “Black Monday” market crash (down 20 per cent in one day), the financial crisis of 2008 and the 2001 “tech wreck”, I believe the risk markets will eventually normalise and recover.
Just like most historically futile attempts to fight the Fed, I would not want to make a long run bet against human ingenuity in developing reasonable workarounds to the fear pandemic and ultimately defeating the virus itself. But it will take time, patience and sacrifice.
One of the best indicators of market sentiment is the Chicago Board of Options Exchange Volatility Index or Vix, sometimes called the “fear index” which measures the expected near-term volatility of the stock market. The index is widely recognised as a gauge of investor nervousness at a point in time.
As of this writing, the Vix has been registering over 70, a level not seen since the credit collapse and Great Recession of 2009.
In hindsight, buying when fear was the highest turned out to be a great opportunity. Almost anything purchased during the 2009 panic worked out as a profitable investment in the years ahead. The stock market doubled, then tripled from base prices.
The world is probably looking at a recession scenario with the first quarter of this year bearing the brunt of the downturn. Even if we do not have a technical recession — defined by two or more consecutive quarters of negative economic growth — global growth could slow to stall speed and for many people this will feel like a recession.
Business and government leaders have bought into the fear pandemic and issued a massive response on two sides. Shutting down air transportation while closing borders and retail outlets will clearly have a negative impact on growth. However, the Federal Reserve and other world central banks are attempting to counter these effects by slashing interest rates while implementing other extreme measures such as increasing the Fed's balance sheet by $700 billion through quantitative easing.
Remember that we are dealing with fear much more than the actual impact of the disease. Setting aside the human element for a moment, having a few thousand or even a few hundred thousand sick or incapacitated (mostly elderly non-workers) out of 7.7 billion people in total will not materially affect economic growth. On the other hand, lower economic activity due to the fear factor is all but assured. Therefore, a “back to work” mentality will be the best defence against a more severe economic contraction leading to credit defaults and further precipitous market declines.
One key variable to watch in the weeks and months ahead will be evidence of a decline in the number of new cases in Europe and the United States. We are watching this closely. Where a levelling off has begun to happen in both China and South Korea, those economies and markets are beginning to show signs of life again. As of last week, the top 16 automakers in China resumed operations at 84 per cent of their plants. However, this information is not being well reported as it's less exciting as the Armageddon narrative.
Importantly, consumers and governments tend to be most afraid of what they do not know. As testing kits become more available, the pandemic will be more measurable which in itself should boost confidence.
Expect though, that reported new cases are likely to rise in the short term. More testing will inevitably lead to more cases being diagnosed. In the meantime, spooked markets will take some time to settle out. Credit spreads and corporate bond prices need to stabilise first, then equity markets can begin to recover.
Importantly, corporate earnings are likely to be marked lower over the next quarter or two as supply chain disruptions and flagging demand take their toll. Market bell weathers such as Apple and Microsoft have already warned on this.
Ultimately, lower interest rates and an accommodative Fed will be helpful. While central banks used up much of their monetary stimulus ammunition in recent years, near zero US government bond rates should eventually push investors back into riskier assets once again, after the dust settles.
During the most recent market downdraft, some defensive sectors like electric utilities have sold off as much as everything else. Currently, we like certain regulated utilities in a heightened “work at home” environment where consumers are using more juice.
Other prospects include select healthcare, biotechnology and diagnostic companies in addition to technology companies which enable remote access. In fact, a large portion of the entire technology complex may benefit in the long run as employers are forced to rethink their contingency and digitalisation strategies. Laptops anyone?
In the bond market we are also beginning to see many good values as some fixed income and ETF investors indiscriminately liquidate positions to shore up their liquidity positions.
Long-term investors should proceed confidently, but slowly. I agree with economist John Mauldin, who likens the coronavirus situation to a baseball pitch known as the “change-up”. That's a pitch designed to look like a fastball while actually going slower. Batters must be careful not to swing too fast at such a pitch or they may have a few unwelcome strikes.
This analogy makes sense, as we are probably at least six months to a year away from a proven vaccine which would allay many fears and get people back to work and life as usual. Wading back into the markets slowly and selectively is therefore our recommended tactic.
• Bryan Dooley, CFA is the Senior Portfolio Manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority