by Sam Sweitzer

Over the last week and a half, markets have traded with no interest for anything but fear around the spread of the Covid-19 coronavirus across the world. Inadequate organization and government response haven’t helped, but the size of equity and interest rate declines have reached a scale that isn’t explained by pricing of an uncertain event. We recommend that investors try and maintain a sense of perspective: The decline in stocks this week was just as much a function of panic selling over fears of what could happen as a reasonable update to the likely trajectory of the economy and risk assets. That doesn’t mean selling is over; while a number of indicators would suggest forward returns from current levels should be pretty good, further declines in the near-term cannot be ruled out. In this environment, investors are best-served by accepting and ignoring volatility, rather than taking it as a signal of inevitably worse outcomes pending.


 
We have just experienced the fastest 10% drop from a market peak in history.



Analysis of subsequent returns after a 10% drop is mixed.  Continued volatility—both up and down—seems likely.



Updated analysis indicates that Covid-19 is 2-3x more contagious than the seasonal flu. Mortality rates are estimated to be 2.3% within China and 0.7% outside of China.

We see 3 potential scenarios:

1.  Quick containment: The coronavirus outbreak is contained by the end of March.  China gets back to full productive capacity by May.  Central banks step in to ease financial conditions during March.  In this scenario, most of the downside has probably already happened and the coronavirus amounts to a one-time, exogenous shock.

2.  The ‘near miss’ scenario:  The virus becomes contained over the next 3 months. China, Korea, Italy, and other smaller economies experience a 1 or 2 quarter contraction followed by a sharp recovery in Q3 and Q4 of this year.  The US economy slows due to travel, supply chain, and consumer spending constraints, but avoids a recession.  Historical analysis suggests that the US stock market would experience a 20% correction, but would recover after this drop.

3.  The prolonged global recession scenario:  The US and European countries experience significant (but not pandemic) coronavirus outbreaks.  China experiences incomplete success in containing the virus and Korea sees its outbreak grow significantly.  Global travel grinds to a 3 or 4 month halt.  Factory closures cause significant supply chain disruptions.  Consumer confidence plummets thus causing consumer spending to contract.  Historical analysis suggests that the US stock market would experience a 30%+ correction in this scenario and the bear market could last 12 to 18 months.



Research conducted by LPL and FactSet concluded that the average bear market correction is -24% when NOT associated with a  recession. When associated with a recession, the average bear market correction is -37%.

Key Economic Transmission Channels:

•Containment efforts – Closed factories means no output is produced.
•Supply chains – The reliance on an impacted area, such as the Wuhan region of China, for intermediate inputs can delay deliveries.
•Tourism – Travel controls and fear can slow dependent service industries.
•Spending – Consumers may defer discretionary purchases by avoiding busy retail centers.

If there’s anything of a silver lining to the dent in global GDP (gross domestic product) the virus is expected to cause, it’s that history suggests that, if/when this virus is ultimately contained, we should expect to see a rapid normalization in economic growth rates and corporate fundamentals.

Key Watchpoints for Investors

•The duration and breadth of the epidemic – If it accelerates into April and drags down Q2 data or spreads more prominently to other countries.

•Non-linearities – If companies fail, creating negative ripple effects (e.g., the closure of Chinese movie theaters). Given the interrelated nature of global supply chains, this is a risk we are closely watching.

•Policy response – If fiscal and monetary authorities step in with ample liquidity to prevent the above.