Coronavirus, The Economy, and The Stock Market: What You Need to Know

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Investors and economists have been squarely focused on the spread of the new coronavirus, officially referred to as COVID-19, and its impact on the global economy. Government efforts to contain the spread of the virus (such as school closures and recommendations to stay home) have already impacted economic activity around the world.

Coronavirus and “Virus Volatility” in Financial Markets

This slowdown in economic activity has resulted in a stock market pullback (temporary decrease in value) over the past two weeks that some have referred to as the “coronavirus correction” and “virus volatility.” Investors naturally have many questions about what lies ahead.

Viral outbreaks can inspire fear and panic. It’s for exactly this reason that investors should continue to maintain level heads and see through short-term noise. 

In order to objectively understand what these issues mean in the long run, it’s helpful to disentangle the topics of public health, the economy and the stock market by addressing these questions:

  • How widespread is the coronavirus?
  • How have markets reacted to past epidemics/pandemics?
  • Will coronavirus cause a recession?
  • Why did the Fed cut interest rates?
  • How might the market respond in the coming months?

When it comes down to it, it’s important for investors to maintain perspective in times of uncertainty. What happens in the intervening days, weeks, or even months is not only immaterial, but overreacting to these events can actually be harmful to investment portfolios. Investors who can stay disciplined are more likely to achieve financial success (you can find proof of that here).

1. How widespread is the coronavirus?

The coronavirus has spread quickly since the end of January and is now reportedly on every populated continent. Since most investors, including ourselves, are not public health experts, the spread of coronavirus is the most uncertain and difficult issue to analyze. In this instance, we must rely on expert opinions and published data while not jumping to conclusions.

Chart 1: Coronavirus: Global confirmed cases, deaths, recoveries; and cases in China

corona virus chart 1
Source: Clearnomics, Bloomberg

At the moment, the data show that confirmed cases continue to rise globally but are slowing in China. The mortality rate, as reported, has been in the 3% range, depicted as the shallow red line on the chart above, with most deaths occurring for those who are elderly or have pre-existing conditions. The corresponding recovery rate has been high and rising. The overall numbers are magnitudes smaller in absolute terms compared to the seasonal flu, although the mortality rate is significantly higher.

Thus, although it’s still unclear when and if the virus will be contained, the bigger challenge from a markets standpoint is the potential for unnecessary fear and panic. Viral epidemics are by their nature scary subjects and, in our everyday lives, it’s difficult to not react. When it comes to our investment strategies, however, panic is the least useful emotion.

2. How have markets reacted to past epidemics/pandemics?

Understanding the history of epidemics and pandemics helps to provide some limited guidance. Prior episodes over the past two decades, including SARS, avian bird flu, H1N1, MERS, Ebola and Zika, resulted in public attention but had few lasting market reactions. In fact, other factors played much larger roles in each episode.

Chart 2: Stock Market Reaction to Epidemics
Recent epidemics and possible pandemics; S&P 500 total returns. Market bottom calculated from Google Trends.

corona virus chart 2
Source: Clearnomics, Standard & Poor’s and Google Trends

The chart above highlights these cases and uses Google Trends data to pinpoint the periods of peak public concern. In each case, markets dipped briefly – often for other reasons – before recovering over the coming months and quarters.

These “other reasons” are important. The SARS outbreak occurred in the wake of the tech bubble which affected markets for years. Avian influenza occurred during the housing boom, MERS and Ebola during the Eurozone crisis, and Zika coincided with an oil price crash and period of concern over Fed rate hikes.

Of course, these past cases were of smaller magnitudes with mostly localized impacts. Still, history suggests that unless there is a serious disruption to the structure of the economy, growth can recover and markets can move on.

3. Will coronavirus cause a recession?

The effort to contain the spread of coronavirus in many countries has already had an impact on supply chains. The outbreak in China also coincided with the lunar new year, effectively prolonging the period during which industrial activity was shut down. U.S. companies have been reporting supply disruptions over the past two months as a result

Chart 3: Global Economic Activity Indexes
U.S. Manufacturing ISM and China Manufacturing PMI; numbers above 50 represent economic expansion

coronaviruschart3
Source: Clearnomics, Bloomberg and Institute for Supply Management

This slowdown can be seen in the February economic data. The chart above shows indicators of manufacturing activity in China and the U.S., both of which have decelerated recently. In China, it should not be a surprise that activity contracted last month due to whole cities being quarantined and companies shutting down. What would be surprising is if this continued to be the case once factories are back up and running.

It’s undeniable that growth has decelerated due to lost economic activity. However, a one-time loss of output is very different from suggesting that there will be a prolonged recession. If coronavirus can be contained, or if recovery rates are high enough for people to return to work, then economic activity can get back on track – even if it takes some time. In textbook economic terms, this may be a classic “shock” to the system that causes a short-term decline in growth which is often followed by a rebound.

For long-term investors, the U.S. economy is still fundamentally healthy. Despite the coronavirus, unemployment remains near historic lows, inflation is still tame, and corporate activity is vibrant. Despite short-term fear and concern, the data does not yet suggest that these trends will change.

4. Why did the Fed cut interest rates?

In response to the short-term economic data above, and in an effort to be cautious, the Federal Reserve announced an emergency interest rate cut of one-half percent on March 3. This was the first emergency move by the Fed since the 2008 global financial crisis and took place two weeks ahead of their scheduled mid-March meeting. At the moment, the federal funds rate sits at a range of 1 to 1.25% – a level last seen in 2017.

It’s clear that rate cuts cannot solve the underlying problems related to the spread of coronavirus – a fact that the Fed understands – nor can it spur activity in all parts of the economy. The best the Fed can do is to bolster confidence and reduce frictions in financial markets. Like their other recent rate cuts, this amounts to an “insurance cut” in that it may help to prevent other problems down the line.

One immediate result of the rate cut was that interest rates across the yield curve declined. The 10-year Treasury yield fell below 1% for the first time ever. Investors who need portfolio income will need to continue to find it from alternative sources. However, those who are in a position to take advantage of low rates, such as through mortgages or refinancings, might continue to benefit.

5. How might the market respond in the coming months?

The bigger issue around the emergency Fed decision is that a 50 basis point rate cut was already widely anticipated. Since 2008, many investors have come to rely on the Fed to bail out the stock market. This is often referred to as the “Fed put” since it is akin to a put option which protects investors on the downside.

For long-term investors, however, it’s still more important to focus on economic fundamentals, valuations and corporate earnings. Following the recent market pullback, the overall stock market valuation has fallen somewhat to levels last seen in 2018.

Chart 4: Stock Market Pullbacks
The number of 5% S&P 500 pullbacks experienced by investors each year

coronavirus chart 4
Source: Clearnomics, Standard & Poor’s

Additionally, it’s normal and expected for the stock market to swing in either direction on a short-term basis. In fact, several 5-10% moves are quite common each year. The chart above shows that investors have experienced two such moves in recent weeks and that, historically, the average year experiences several of these pullbacks before recovering.

In fact, when the market does recover from corrections, it often does so swiftly and without warning. Those who try to jump in and out of the market to avoid short-term declines often miss the subsequent rebounds. At least two significant positive stock market moves over the past week illustrate this point.

In the end, much of investing is emotional and behavioral. A steadier ride helps investors to stay on track and not overreact to short-term developments.

For more resources, keep checking the COVID-19 section of our blog here. We’ll be updating it with new information regularly.

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