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Pandemic Risks and Reactions

Aaron Costello, CFA

Global equities sold off sharply this week as cases of COVID-19 spread rapidly outside of China (particularly in Korea, Italy, and the Middle East).

While the spike in volatility has been abrupt, the current market sell-off is arguably a needed correction. Even before the rise in global infections, markets were grossly under-discounting the virus’s impact on Chinese and global growth. As discussed in our January 30 CA Minute, the drastic measures taken by the Chinese authorities to combat the outbreak will impact growth more than during the SARS epidemic, given the current size of the Chinese economy and its role in global supply chains and global demand. Even as both hard data and anecdotal evidence were suggesting the Chinese economy was operating at about half its normal levels in mid/late February, global equities were hitting new highs. Thus, while we expected markets to recover from the January sell-off, they did so more quickly than fundamentals and economic realities would seem to justify.

While previous virus outbreaks provide some insights, in reality, no one knows what will happen—not epidemiologists and certainly not market strategists—but here is what we can reasonably surmise:

  • The number of cases globally will continue to rise. Even in China, where the number of new cases has fallen sharply, there is a risk that infections will rebound in the coming weeks as travel restrictions are lifted and employees return to work. We do not know whether outbreaks outside of China will be widespread or will overwhelm local health systems, especially in the United States and Europe.
  • Economic and earnings data will be very poor in first quarter, and backward-looking data releases over the coming weeks will not provide much clarity. Economic uncertainty will not disappear anytime soon.
  • Markets have not yet priced in a worst-case scenario of a global recession and may not have bottomed. Given the still-elevated level of equity valuations, there may be more downside from even a modest economic shock. Hindsight will tell us, but historically markets do not bottom until new infections peak.

Investors should avoid trying to time the market or make portfolio moves that imply high conviction in any one scenario. They should use portfolio diversification as the best line of defense for this sort of uncertainty and volatility. In particular, assuming the portfolio is in line with its strategic asset allocation, we would not cut risk given that global equity markets often recover sharply from exogenous shocks. This time around, the recovery is likely to be aided by fiscal and monetary stimulus, both in China and globally.

Investors should monitor portfolios closely and be prepared to rebalance as needed, especially if safe-haven assets continue to rally and risk assets continue to fall.