Baldwin Investment Management

Shoot First, Then Ask Questions…

More than $4 Trillion (that’s with a T) of market value was stripped from US equities in the space of a week. Such a cascade of selling over such a short period has rarely been seen in American stocks since records have been kept. And in this instance, the spark did not come from a market anomaly or an economic “infarction” – rather it came from a more primal fear of mass contagion and its attendant unknowns. This is or could be “scary stuff”. But before panic sets in, let’s review the outbreak of Covid-19 (also known as coronavirus), anticipated economic impacts, and the markets.

Scientists have determined that Covid-19 is highly contagious and there now seems to be evidence of community spread (i.e. the immediate cause of someone’s infection is not readily determinable, thus the virus is present in a community). The mortality rate is hovering around 2% and is heavily skewed to the over 65 age group and those whose immune systems are impaired. The virus is present in the US and in tens of countries around the world. The origin of the virus was Hubei province in China.

Regarding the US economy, consumer confidence in February was measured at 130.7 vs. a score of 130.4 in January. The Chicago PMI (Purchasing Manager’s Index) registered a score of 49 in February, a six-month high. Core durable goods orders (a measure of corporate capital expenditures) rose 0.9% in January vs. an expectation of +0.2%. New home sales and pending home sales both exceeded expectations in January. Corporate earnings for Q4 2019 were stronger than Wall Street had expected. But several companies did note in their quarterly reports that their supply lines from China were compromised. Consequently, numerous companies downgraded their immediate quarterly outlooks because of logistics difficulties. So generally, the American economy continues to move ahead according to the latest economic data – but some companies anticipated facing earnings problems because of supply line disruptions coming out of China.

Elsewhere in the world, China’s economy is expected to weaken in Q1, due to the Covid-19 outbreak and the government’s response of quarantining millions of people. However, it has already been reported that millions of workers are beginning to return to factory floors in less affected areas. European nations are just now facing increased counts of infection. But it is too early to know what the official anti-infection policy will be in each jurisdiction and gauge its effectiveness. In Asia outside of China, Japan and South Korea are beginning to battle their infections and there is spread into Vietnam and Thailand. It is supposed that in each instance the economy will take “a hit” in the short term. But it also has been calculated by various economists that the drag on most economies will be brief and mild – i.e., GDP down 0.1% – 0.3% for a quarter or perhaps two quarters.

As time has been so short since the “downdraft” started, it is difficult to say that anything economically fundamental has changed since February 19, the recent market high. What has changed is the degree of fear regarding Covid-19. Without knowing results as to how mild or severe Covid-19 will disrupt companies and economies around the world, some investors have simply “shot first” by selling higher risk assets such as equities and commodities. Questions will follow. To get a picture of this, please find two charts – the first looks at the S&P 500 and its sectors and the second examines bonds/commodities.

Source: Bespoke Investment Group, Morning Lineup 2/28/2020

As can be clearly seen, across the board American equities are oversold, with most sectors dramatically oversold. With regard to bonds, they are extremely overbought, and commodities are oversold. This story is pretty much the same around the world, as some investors have eagerly sought out safe havens and rejected risk of any flavor.

At the top of this note, we said that Covid-19 is or could be “scary stuff”. We stress the words could be because we do not have enough information to know whether the infection will or will not be “scary”. Not everyone gets sick from the virus and of those who sicken, not everyone gets seriously sick. Experts have told us that Covid-19 is less deadly than Ebola, SARS or MERS. It may be more deadly than influenza. But remember that 99% of the deaths so far registered have occurred in China – not a country with a public health system considered to be of first world quality and certainly not one that compares to the US. There is no vaccine to combat Covid-19, but numerous companies are working on one and we anticipate that work will be accelerated. The American economy is not showing any signs yet of weakness. Some companies have warned of supply line problems or sales problems in China, but nowhere else. Again, the economic fundamentals have not changed dramatically for the worse. But certainly, market pricing has changed, and this is the disconnect. When one owns part of a company (i.e. equity shares) one is buying a stream of earnings that extend well into the future – not simply over a couple of quarters. To believe that today’s stock prices accurately reflect corporate value, one must believe that Covid-19 will not be a short-term phenomenon and that there will be substantial and permanent earnings destruction. Alternatively, if Covid-19 is effectively controlled by first world health care systems, then there most likely will be no earnings destruction, but rather a couple of quarters of earnings delay. We subscribe to the second scenario.