2020-03-02 Normally I don’t like to talk about the news as I focus on reports and data however there is a lot of reports and data in the news last week. Coronavirus has been all consuming to the markets and the developments have been quick. 

To me the difference is that news can consist of data but is largely focused on op-ed and conclusions are drawn by other people, many whom are unqualified to make those conclusions. There are also the personal feelings that get displayed by the reporters as they tell the story.

I do my best to avoid reading other people’s opinions until after I have looked at the data, facts and formulated my own conclusion.

These situations are the reason that I ask my two famous questions to every client: How much cash do you need and when do you need it by?

This is why I structure portfolios with 5-7 years of cash needs set aside in fixed income before focusing on the more fluctuating growth part of the portfolio. This allows for income to be protected and it allows for volatility which is designed to create more wealth over the long term.

Before I talk about the changes I made to portfolios last week let me set some context for what I have observed, how I see it possibly unfolding and why I decided to make changes.

In my latest post HERE I discussed the Coronavirus and confirmation bias. Confirmation bias is what happens when someone only looks at new information that confirms what they already believe to be true. They don’t take an objective look at new information properly.

This leads to two possible errors. The first being someone who ignores new information and underreacts because it doesn’t fit their pre-existing beliefs. The second is when someone overreacts to new information because it confirms their pre-existing beliefs.

My job as a portfolio manager is to be as unbiased as possible. In order to do that let’s review what I know so far. This isn’t an exhaustive list but these are the most significant reports that I’ve come across in my opinion. Let’s also be clear that I am an analyst, not an epidemiologist.

Prior to February 22, 2020

  • The infection rate in China has caused hospitals to become overrun. Around 60,000 infected in the last two months.
  • Government response to the virus was “containment” hoping to slow the spread of the virus so that they can cope with the infected
  • Containment was/is isolation and distancing of people and reducing travel both within the country and between countries
  • Reports of many farmers not being able to get feed for their livestock which would require the slaughtering of millions of chickens or they would suffer
  • Much of China’s Hubei province is under lock down and quarantine
  • Some cruise ships were not allowed to dock and had to remain at sea
  • The Diamond Princess cruise ship was in quarantine off Japan as infections continued to rise
  • Many flights to China were restricted or cancelled

At this stage a wait and see approach was warranted. The virus was largely contained to China and was starting in South Korea and Japan but was not a major issue for the rest of the world. The economic effect of the shutdown in Hubei province was unknown however I read that it was a busy transportation hub for goods and services. Later I found that it ranked 2nd for economic output among Central China’s provinces.

Much was unknown about the virus, how it spreads and who it affected. The economic impact had not been felt at this stage outside of airlines, cruise lines and oil producers as they saw a decrease in demand for crude from China and oil prices had dropped.

Medium term effects from lower oil prices were seen as reduced inflation and possible pressure on energy stocks. Hints at increasing prospects for lower interest rates.

Weekend of February 22 & 23, 2020

  • China had over 70,000 infections since the middle of December, about two months
  • Death rate in China was fluctuating around 2%
  • Iran reported infections and stated formally that there was only 12 people who died but reports coming out at 50
  • Turkey closes the border with Iran to reduce possibility of virus spread
  • Iranian deputy health minister was on television stating that he would resign if there were half of the 50 reported deaths and that those reports were fake while downplaying the number of infected people. On that viewing he was sweating profusely and wiping his head. Later that night he was confirmed to have contracted COVID-19.
  • Italy confirmed 400 cases and quarantined a large portion of northern Italy
  • French train engineers were refusing to go into Italy
  • Many of South Korea reports a large influx of 600 cases and is found to be circulating in some very large churches

The theme of containment began to emerge as a possibility throughout the world. The closing of borders was high on my assessment list.

If the 50 deaths in Iran were accurate then that would mean that 2,500 people were infected and not the 200 that they were claiming. Further, public meeting places refused to close which would have allowed the virus to spread easier.

February 24 to March 1

With Hubei province in China already on lockdown and goods not being produced or shipped this is an economic problem. The flow then stopped between Iran and Turkey. Italy and France began to see reduced flow.

The biggest determination from a portfolio standpoint is to understand what the economic impact will be. Many of the epidemics in the last 100 years have had little long term effect on the stock markets.

Supply chain issues began to arise in my mind only later to become confirmed. Given the closure of borders and restriction in life in affected areas I believed this to be a concern economically and we would not be able to contain the virus to certain countries. I believed that it would eventually spread to North America and that it would affect life, demand for goods and services and production here.

As you may know most of the stock exposure for clients was the US S&P 500. I had already been slightly underweight stocks so I decided to move 30% of that exposure for all clients into Canadian utility stocks.

The rationale was that if sales, revenues and balance sheets were affected then I wanted to insulate portfolios. Utilities are a traditionally defensive place to be as their revenues will be largely unchanged in a recession and this bodes well should interest rates decrease as they have large borrowing costs which helps with their margins. Further when bond yields compress investors often seek higher yields in these types of stocks.

The S&P 500 dropped 3.35% that Monday and stayed at low levels most of the day. Not able to make the adjustments and hoping for a bounce I was able to make the trades part way through the fall on Tuesday.

This trade worked very well until Friday when everything sold off and the VIX, which is a measure of protection and fear in the market, hit one of the highest levels of 49. To put this into perspective the VIX hit around 60 only briefly in the credit crisis. The chart over the credit crisis is a quick spike up to be followed by a quick drop. For context the VIX normally sits between 12 and 20 with 25 being very high.

This led me to believe that everything was being sold and the desire for quality stocks was being disregarded. My apologies for the horrible analogy but it was a “throwing out the baby with the bathwater” scenario.

A “correction” in the markets is defined as a 10% drop from recent highs. This was the fastest correction on record as the S&P 500 fell around 11.5% last week. Monday and Tuesday both dropped over 3% and Thursday saw a greater than 4% drop. Every day was a negative day.

This shows an extreme reaction in the markets and a bounce back is expected. More news will be needed to confirm this negative sentiment with spread throughout the community in North America.

Given the amount of international travel and the gestation period of the virus I feel that transmission globally is inevitable and will eventually spread to Canada and the United States. Only time will tell if I am correct.

Other notable news over the week:

  • Japan and South Korea closes most schools
  • Vehicle sales in China down 92% the first half of February
  • Hyundai closes a plant in South Korea over the inability to get some parts shipped from China
  • FDA announced shortage of one of the medications but didn’t specify which one. A number of mediations are made in China.
  • US Centres for Disease Control and Prevention spokesman issued a press briefing outlining the American public to prepare to work from home, cancel in-person meetings and closures of schools and child care centres. He said “I told my children that while I didn’t think that they were at risk right now, we as a family need to be preparing for significant disruption of our lives.” 

Due to the migration of sick people that are likely unknowingly transmitting the disease, we will get a better picture of impact in the US and Canada over the next few weeks. 

One man travelled from Japan without symptoms to Maui, Hawaii, spent 7 days there then travelled and spent 4 days in Oahu at which point he began to experience cold-like symptoms. When he arrived home he developed severe symptoms and sought medical help at which point he was confirmed to have COVID-19.

I believe the strategy of containment will be a dominant theme affecting the flow of people and production of products.

While this sounds scary, it is reported that many will not be affected even if they are infected and many will only have mild cold-like symptoms. A portion of the infected will have more severe conditions and less will be fatal.

Again, it is my understanding that containment is used to slow the spread of the virus so that hospitals can cope with the number of infected.

The important thing here is to focus on the economics and not the fear that all this information may insight. 

Now for the good news:

  • Interest rates will likely head lower
  • This will eventually pass
  • The majority of deaths are people over 60 with pre-existing conditions which is a narrow demographic.
  • *This is insensitive and incredibly sad* however people over 60 with pre-existing conditions are typically more expensive on the healthcare system than the general public. Depending on the spread and deaths that the virus causes this could help to reduce that expense over the long term should it affect a large proportion of that demographic. 
  • The selloff will provide an opportunity to buy more stocks and more cyclically oriented stocks at better prices

Of course with all changes there is opportunity.

Over the medium to long term, I believe this is a temporary event that needs to be navigated and the markets and life will go back to normal operation. Humans are an incredibly adaptive species and will overcome adversity.

I am looking for a lower point in the market to buy in at cheaper levels and switch back into more cyclically oriented stocks. I believe this will occur prior to getting the all clear signal from the news outlets on the virus spread.

My concern is that if this affects the Canadian consumer then a recession will be hard and deep. The Canadian consumer is already heavily indebted and I believe they will feel it fairly quickly and hard. For this reason my preference is to avoid Canadian stocks in favor of US stocks as they have much healthier balance sheets.

I am also avoiding emerging markets and high yield bonds right now.

In conclusion:

  • Look for quality
  • Buy in at good prices
  • Look for the data and avoid opinion

I hope this provides some context to the virus, your portfolio and answers some of the questions that you may have. I am always happy to answer questions and feel free to reach out.

Until next time,

Trevor Dale, CFA

Sources:

Hubei province economics

Visual Charts

Iranian Deputy Health Minister wiping head not knowing he was infected

Potential culling of millions of chickens

Spread inside South Korea’s churches

China vehicle sales first half of February 2020

Japan man travelling in Hawaii

CDC teleconference to America

Fastest correction on record

World Health Organization Coronavirus Situation Reports