Investment Strategy Insights: With Coronavirus, Are Markets Fearing Fear Itself?

Author:
Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

4 February 2020

Coronavirus fears are dominating headlines, and concerns that infections will mount justify keeping the potential toll of human suffering front and center. Yet for markets, it’s important to put the virus’ likely economic impact into perspective. If past is prologue – admittedly a big “if” – the effects on the economy and markets may well prove short-lived.

It’s worth recalling the generally inverse relationship between an influenza strain’s ability to spread and its fatality rate. Indeed, to find flu epidemics that are both truly global and highly fatal, we may need to look back as far as the avian flu of 1957–1958 (which killed an estimated 1 million–2 million people worldwide) or the Spanish flu of 1918–1920, which killed about 50 million people worldwide with a fatality rate as high as 20% among those infected.1 They are that rare. In comparison, the coronavirus fatality rate is currently estimated at only 2%–2.5%.2

The more recent SARS and MERS epidemics provide additional context. While the fatality rate was high for Severe Acute Respiratory Syndrome, or SARS, at 9.6%, less than 8,100 cases (and 774 deaths) were reported.2 And while the fatality rate for the Middle East Respiratory Syndrome, or MERS, was much higher at 34.5%, it was limited to just 2,500 cases and 861 deaths.2

True to form, while the coronavirus fatality rate appears much lower, its spread has been faster and wider. The question becomes whether the resulting fear and disruption are justified – especially when we consider that the common flu kills between 12,000 and 61,000 people in the US alone each year (according to the Centers for Disease Control for 2010 forward). With well understood fatality rates in the 0.2% range, the common flu doesn’t inspire the fear (and thus the economic disruption) of its more novel cousins.

It’s also worth noting that the word “pandemic” being thrown around today is likely misunderstood. It only refers to a disease’s ability to spread across regions, not its potential fatality. Perhaps we need a new, broadly understood label that encompasses both spread and fatality rate, to avoid unnecessarily triggering panics.

Lastly, the impact of viruses has tended to be relatively short-lived. Dr. Pierre Talbot, a Canadian researcher, believes the virus will likely mutate and initially become more serious, but then just as quickly return to the animal population from which it originated, calling the public’s almost panicked reaction to the disease “strange.”3

If the effects of Wuhan coronavirus dissipate this spring, which appears the most likely scenario, investors may find that not much in the global economy has fundamentally changed. True, damage will likely mount over the next several months, particularly in travel, oil, and the Chinese economy. And given China’s size and significance, weakness will spread elsewhere. Yet keep in mind that much stimulus had already been put in place to reverse 2019’s global slowdown. Similarly, with SARS, an actual 2000–2002 recession resulted in comparable policy measures. While SARS delayed that recovery by a quarter, it took hold nonetheless. This too could prove to be a dip to be bought.

1 Source: CDC.gov. 2 Source: World Health Organization. 3 See “Coronavirus epidemic should be contained within a few weeks, expert says,” Montreal Gazette, 28 January 2020.

Conviction Score (CS) and Investment Views

The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.

Global Economy

Markus Schomer, CFA
Chief Economist,
Global Economic Strategy

CS 2.75 (unchanged)

While non-macro-related headwinds such as Brexit and the US-China trade war have abated, underlying uncertainties including more volatile US economic policies haven’t disappeared. We still believe developed world economies have moved to a post-cycle stage in which less cyclical growth rates are converging to their underlying potential rates; for 2020, this means modest growth. The persistent structural shortfall of inflation in the developed world will continue to force central banks to maintain rates below neutral and revert to more quantitative easing (QE), which should keep bond yields low and prevent the corporate defaults that could spark the next recession. Still, while recession risk has greatly diminished, there is no convincing evidence of a rebound in the developed world.

Asia Economy

Paul Hsiao
Economist, Global
Economic Strategy

CS 2.75 (unchanged)

We maintain our slight bullish skew despite the uncertainty sparked by the outbreak of the coronavirus in China, where macro data had been showing modest improvement. A re-escalation of the US-China trade conflict remains a possibility as the Phase 1 trade deal’s aggressive purchase elements pose risks for China’s trade partners and set a very high bar for compliance. Other Asian growth risks include ongoing Hong Kong protests, a decisive pro-democracy win in Taiwan, internecine squabbling among factions of the Chinese Communist Party, and the continued strength of the US dollar.

Rates

Gunter Seeger
Portfolio Manager, Developed
Markets Investment Grade

CS 3.00 (unchanged)

After a Goldilocks month in which the prices of bonds and equities rose — due, no doubt, to favorable geopolitical events and a Federal Reserve firehose that drowned the repo market’s problems with liquidity — the coronavirus reared its head and shook the rates market. Prices of Treasury Inflation-Protected Securities (TIPS), which already were cheap on a breakeven basis, became even more so. While the market had been pricing an inactive Federal Reserve over the near term, it is now predicting another cut later this year.

Credit

Steven Oh, CFA
Global Head of Credit and Fixed Income

CS 3.50 (-0.25)

Improving fundamentals are currently in a tug-of-war with deteriorating valuations. Normally, the tension would lead us to raise our conviction score, but we are choosing to remain defensive since shifts in technical and market sentiment can be sudden. Moreover, record supply has kept investment grade (IG) spreads from shrinking to the record tight levels in the BB market, making IG a more favorable place to be. The gap between the BB and B markets has narrowed but continues to favor the single-B space from beta and alpha perspectives. While we believe loans still offer attractive risk-adjusted returns, the current repricing wave may significantly dissipate the value advantage. Mezzanine collateralized loan obligations (CLOs), which lagged in 2019, are gapping higher, making this a good time to de-risk and move up in the capital structure.

Currency
(USD Perspective)

Anders Faergemann
Senior Portfolio Manager,
Emerging Markets Fixed Income

CS 3.00 (unchanged)

Despite starting 2020 on a high note, we believe the euro will continue its head-to-head stalemate with the US dollar, keeping foreign exchange markets in the low-volatility state they have experienced since summer. Market participants find it hard to distinguish between the major currencies, although the Japanese yen appears vulnerable to further weakness due to the easing of US-China trade tensions, which had made the yen a safe haven. The yen also has been hurt by speculation the Bank of Japan may move interest rates to neutral, a move the market believes could undermine prospects of a growth recovery.

Emerging Markets
Fixed Income

Steve Cook
Co-Head of EM Fixed Income
and Head of EM Corporates

USD EM (Sovereign and Corp.)

CS 2.50 (unchanged)

Local Markets (Sovereign)

CS 2.50 (unchanged)

Our CS remains unchanged given the current stable fundamental backdrop and supportive environment, in which spreads continue to grind tighter across US dollar components despite material supply in primary markets, especially in Asia. Inflows have been strong, easily taking down the primary issues that have come with almost zero new-issue premia. Since global investors generally are underweight Asian EM debt, which is 85% owned by locals, recent market skittishness due to the coronavirus outbreak has been largely self-contained. The spread-widening that is occurring represents a potential buying opportunity once there is greater clarity on the public health front.

Multi-Asset

Jose Aragon
Portfolio Manager,
Multi-Asset

CS 2.00 (unchanged)

Markets sense that the worst is over. Economic fundamentals are improving, monetary policy is revving up, and trade hostilities are receding. Renewed risks in the Middle East only partially offset our optimistic view, and we maintain our constructive CS of 2.0. We expect a small but lasting bounce in GDP. Combined with upward purchasing managers’ index (PMI) inflections, the result is more meaningful accelerations of cash flows — which typically pull forward the removal of monetary accommodation. Overall, we see the 2020 economy as being characterized by less fragility and increasing sustainability.

Global Equity

Lizette St. Hilaire, CFA
Research Analyst,
Global Equities

CS 3.00 (unchanged)

Since Fed policy in the US and quantitative easing across the globe accounted for the majority of the markets’ positive rerating in 2019, continued multiple expansion in 2020 will have to come from earnings revisions and other factors. Factors supporting this outlook include company management teams generally confident in their outlooks, consumer spending remaining strong, US-China trade tensions easing, and the more cyclical parts of the global economy — electronics, machinery, and autos — increasing their capex, with a focus on data-capturing and analytic technology.

Global Emerging
Markets Equity

Taras Shumelda
Portfolio Manager,
Fundamental Equities

CS 3.00 (+0.25)

We bring our CS to 3.0 from 2.75 entirely on valuation grounds. While we don’t see the market as expensive, new earnings upgrades will be needed to keep it outperforming. China and Brazil remain attractive EM growth stories. China will continue to benefit from increased social spending and other forms of government stimulus, and although the coronavirus has made global headlines, at this point we are not positioning for a sizable or protracted economic impact. Brazil is in the midst of a reform drive with early signs of success, including a significant rebound in real estate activity. An economic slowdown in India and high valuations make it less appealing than previously.

Quantitative Research

Peter Fwu
Quantitative Strategist,
Quantitative Fixed Income

Our US Market Cycle Indicator (MCI) has improved, moving to the optimistic zone and giving us its first bullish reading since January 2017. In spread term structure, the high yield (HY) long end is cheaper compared to historical levels. We favor EM over developed markets, and by sector we like brokerage, banking, and consumer non-cyclicals, while disliking communications, utilities, and natural gas. Our rates model continues to forecast gradually rising yield levels and a steeper yield slope, which is driven by technical factors, the results of business and consumer surveys, and market-implied policy rate moves. The rates view expressed in our G10 model portfolio is neutral global duration, underweight North America and Japan, and overweight the UK, Europe, and Australia. On curve positioning, our portfolio is overweight five- and 20-year durations and underweight other key durations.