(editor's note: an earlier publishing of this was titled "Corona Virus Impacts," but we have revised this title to reflect the "COVID-19" name for editorial accuracy.)
From the desk of our Portfolio Management Team:
The Impact of COVID-19 for Investors
Public health outbreaks and epidemics like the recent coronavirus can quickly scare investors and, eventually, affect economies and businesses. The recent coronavirus outbreak has shut down airports, halted trade, and led to the rapid construction of new hospitals in China. The effects of the outbreak may push China's economy into a period of slower growth, with stocks trading lower as investors seek protection.
So, what does that mean for the portfolios we run?
Epidemics and Investing
To understand the potential impacts of an outbreak, we must make a forecast—formally or casually. This is a complex task if done correctly, and outside the scope of this piece. But it's important to acknowledge that we're trying to peer into the future, which is wrought with intellectual danger. No one can predict the future, but plenty of research suggest ways that forecasts can be improved.1
One way to improve the accuracy of a forecast is to start with base rates. How often do outbreaks become epidemics? What effect do epidemics have on economies or markets? For this latter question, we look to Exhibit 1 to provide a sense of base rates—market returns following major epidemics in recent history.
Exhibit 1 Investors Tend to React to Epidemics, But the Long-Term Picture is Positive
1 See Superforecasting: The Art and Science of Prediction by Philip E. Tetlock and Dan Gardner. The Notes section cites numerous studies, including those done by Tetlock and his partner, Barbara Mellers.
As depicted, market participants tend to react to such unforeseen outbreaks, but markets tend to recover by the six-month mark. This suggests that sentiment drives early losses, but sustained economic impacts are less than perhaps investors feared at the onset.
Another way to improve forecasts is through humility—especially knowing what you don't and can't know. Expert epidemiologists might be able to produce base rates on spread rates, mortality rates, and so on, but no one can predict how unknowable factors might affect the spread of this or any outbreak. That's not to mention knowing how fear might affect markets.
So how can we make a reasonable assessment of the potential impact of the coronavirus? As long-term, valuation-driven, fundamentally based investors, our concern is any potential impact to businesses' cash flows.2 For example, will the collective impact of the outbreak (fewer flights, less trade, loss of productivity, etc.) affect a few businesses, a few industries, or entire markets? That's the question we're asking.
Our answer is that, at this stage, we have to assume the outbreak will take a similar path to other recent epidemics, and thus we feel there's no reason for investors to be alarmed. Note that there's no "safe" approach for investors—for example, exiting stocks in favor of cash has its own risk, namely crystalizing any losses suffered to sentiment while almost surely missing out on a rebound if the virus were to be contained quickly. So we want to proceed by assuming what we consider to be the most likely scenario, while taking other possible outcomes into account.
Ultimately, we are very watchful but aren't taking any action. Our core ambition is to help investors reach their goals, which requires a measured and repeatable process to investing. Across our portfolio range, we may hold exposure to Chinese stocks, emerging-markets stocks, emerging-markets debt, and companies that sell into China to varying degrees depending on the portfolio mandate. Even so, we are still expecting that these holdings will deliver positive outcomes over the long term, and it would require a clear impact to fundamentals for our view to change.
Note that once the facts change, we would expect to change our minds. If we were to see a clear and significant potential impact to investment fundamentals, we would carefully study the situation, conduct rigorous scenario analysis, and try to incorporate the new information into our portfolios. Until then, we remain vigilant.
With lives at stake, it would be uncaring to call the coronavirus "noise." Yet, if we focus on the investor's perspective, we believe it is not time to act. Moreover, we remain confident in our portfolio holdings because they reflect a solid base of research and resemble a well-reasoned way to invest. We certainly won’t be hitting the panic button and we hope you won’t either.
2 Note that as investors have a particular focus on fundamentals. As humans, we care deeply about the loss, suffering, and fear brought by this or any outbreak. But we mustn't let our emotions drive investment decisions—now or in any circumstance.
Opinions expressed are as of the current date; such opinions are subject to change without notice. Focus Asset Management and Morningstar Investment Management shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only. The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment. Performance data shown represents past performance. Past performance does not guarantee future results.
All investments involve risk, including the loss of principal. There can be no assurance that any financial strategy will be successful. Morningstar Investment Management does not guarantee that the results of their advice, recommendations or objectives of a strategy will be achieved.
This commentary contains certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason. Past performance does not guarantee future results.
Investing in international securities involve additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may increase these risks. Emerging markets are countries with relatively young stock and bond markets. Typically, emerging-markets investments have the potential for losses and gains larger than those of developed-market investments.
A debt security refers to money borrowed that must be repaid that has a fixed amount, a maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper. The borrower pays interest for the use of the money and pays the principal amount on a specified date.
The indexes noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indexes and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Management and Focus Asset Management cannot guarantee its accuracy, completeness or reliability.
From time to time Focus Asset Management shares with their clients articles or news pieces that we believe are of material value to our clients. This does not constitute a recommendation to buy, sell or execute certain securities transactions of any kind, as these publishings are intended for informational purposes only. Please consult with your financial advisor, or a financial professional before making any investment decisions.