In light of recent market moves, we wanted to share our views on the potential impact from the coronavirus (COVID-19) on markets. We, of course, are not virologists and do not have views on the particulars of the virus itself. However, there has been a great deal of speculation on what impact this might have on financial markets. We are not dismissive of these concerns and are monitoring the situation.
There are two aspects to the earnings implications of the virus. The first is the impact on demand from the virus as portions of the population are either required to or choose to limit their contact with large groups of people by avoiding going out in public. It’s worth differentiating between demand for perishable goods and demand for non-perishable goods. One example of demand for a perishable product is a seat on an airplane – there is only one chance to sell a seat on the 9:00 a.m. flight to New York on a particular date. Once that date passes, that sale is lost permanently. Demand for non-perishable goods, like smartphones, is more resilient. If a consumer wants a new phone but is unable to go out and buy one today, they’ll likely still want that phone in a week or a month and make their purchase as soon as is practical. Demand for many non-perishable goods and services is still likely to hold up despite the virus, but sales will be delayed. The majority of the impact to demand for perishable goods is likely localized to China, perhaps Asia at large. While China is of course a large portion of the world economy, the types of firms that are likely to suffer most from reduced perishable demand are not a big part of stock markets.
The second aspect of earnings implications stems from the disruption of the supply chain. As factories in China close or limit the staff available to work, fewer goods are produced. Thus, even if there is demand for a particular product, firms may not have adequate supply to meet that demand which could push sales farther into the future, or eliminate the sale entirely. For firms that both produce and sell in China, this impact is probably somewhat mitigated, as they will not experience an inventory buildup while they are experiencing demand contraction.
Combining these concerns, we realize that if the virus persists for any meaningful period of time it is likely to have at least some impact on corporate earnings. At this point, we have not seen meaningful changes to aggregate earnings estimates, but those changes are likely right around the corner. Until we see what type of reduced earnings expectations the market is pricing in, we do not have sufficient information to judge whether or not the market is appropriately pricing in the risks of the coronavirus.
The worldwide impact of this virus is a classic example of a “black swan” event. No matter how skilled one is at forecasting markets, there is no way to forecast a novel coronavirus sweeping through a manufacturing hub in China and spreading throughout the world in less than a month. However, the fact that unforeseen events like this can and do happen highlights the importance of diversification. All but our most aggressive clients have a measure of high-quality fixed income in their portfolios that has held up very well in the face of coronavirus related concerns. It’s also important to note that while market declines have been concentrated in just a few days, the level of market decline to this point is not yet at uncommon levels. The S&P 500 has seen an intra-year drawdown of 10% or more in 22 out of the last 40 years. The type of volatility we have seen to this point is to be expected, even if the cause of the volatility is highly unusual. This is why we think it is important for clients to understand their risk profile and stick to the risk profile that makes sense for their individual financial independence. We are always open to having these risk related conversations.
Steven Rife, CFA, CFP®
Chief Investment Officer