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The Brave Report: Market Commentary for February 2020

Click here for .pdf version of this report: The Brave Report-Feb 2020

Watch out for the unexpected… With the markets seemingly set to continue their upward momentum from last year, the brakes were put on pretty fast. Going into the year we thought we had a good idea of what the uncertain variables were that would drive the markets.  This allowed us to take the necessary steps to prepare for them or take advantage of them. But, as is often the case in investing, the true unexpected trumps all and can cause sharp moves in the market.

This was the case this month as the Coronovirus outbreak in China put a quick damper on the early year party. Fears of a pandemic and a dent in global growth quickly sent the markets tumbling.  While they have stabilized since the initial pullback, a lot of questions remain.  At first glance, the overall economic impact seems to be muted but the speed at which the virus is contained and treated will be the real determining factor as to its lasting economic impact.

Market Overview

After continuing last year’s upward trend to start the month we saw some selling to close out the month due to fears over the Coronavirus.  The NASDAQ still eked out a slight gain of less than 1% while the S&P 500 and Dow Industrials both lost less than 1%.  This marked the first down month for these indices since August and only the third down month since the start of 2019. With earnings season starting off on a mostly positive note I don’t expect this downtrend to continue. If we can get some clarity around the Coronavirus and its economic impacts than I think the markets can continue higher.

On the fixed-income side, we saw a massive drop in rates as investors rushed to safety later in the month.  After reaching a high yield of 1.9% early in the month the rate on the 10-year treasury plummeted down to a low of 1.51% to end the month. This still keeps the yield above the 3-year low yield that we saw in early September.  The move lower seems very reactionary to the Coronavirus outbreak and is not surprising considering that we were sitting at all-time highs in the equity markets.  Investors used the events in China to take some profits and quickly move to safety.  If the virus gets contained without too much damage, I think rates will probably bounce back quickly.

Coming into the year I discussed several variables that could drive the markets over the course of the year.  Most of these I would put in the category of “known unknowns.” By this I mean we know the uncertainty is there, but we don’t know how it is going to impact the markets.  We know the election will impact the markets, but we don’t know how it will yet.  We know there will be continued trade negotiations with China, but we don’t know how these will play out.  These types of uncertainties can be planned for, handicapped, hedged against or taken advantage of.

On the other side of the equation, and often more impactful in the short term are just the “unknowns.”  We sometimes call these black swan events.  These are uncertainties that surprise us so are much more difficult to plan for.  They also tend to send more drastic short-term shocks (both positive and negative) to the markets as emotional, reactive decision making dominates. The recent outbreak of the Coronavirus would fall into this category.

Coronavirus: With the markets starting the month by continuing to march higher the fear of a pandemic quickly put the brakes on things. Obviously, the human impact of this virus is much more important than the financial side but my job here is to discuss the economic and investment impact so I am not trying to be insensitive to the health toll this is or could have.

Let’s first put this outbreak into perspective. At the time of writing this, there had been 20,000-30,000 confirmed cases and around 500 deaths. It is important to handicap all of this by saying these are the numbers that China is reporting, and their accuracy should be called into question.   Each year in the United States the Flu infects between 15 and 20 million people and kills around 10,000.  The US population is 23% the size of the Chinese population. I  understand that we are still in the early stages of understanding and curing/preventing this new virus strain but at this point it has had a very minimal impact when compared to other similar diseases. I don’t pretend to be an expert in anything medical or health-related, but until this outbreak spreads or its mortality rate increases it seems it will have a very negligible impact on world health.

With that said, even if this virus’s health impact remains small on a global scale that does not mean it won’t have an economic impact on certain regions or sectors. China has taken steps to limit travel, lockdown certain provinces and forced people to remain at home. This will have a short-term impact on their growth this quarter and probably throughout the year. In terms of the global economic impact, slower growth in China will drag on global growth this quarter.  We could also see some sector impact here in the United States. Luxury goods and travel will take a hit as Chinese consumers stay home, and travel is limited to and within the region.  Other companies with large revenue exposure to China could also be impacted.

If the virus can be contained in short order the damage should be limited to just a handful of sectors. However, if this drags on for a few more months and factories remain closed longer than expected than we could see a larger global impact as the global supply chain gets disrupted.  Most companies can handle a short-term disruption but if companies are forced to source elsewhere or cut domestic production because they aren’t receiving supplies from China than we could see some greater downward pressure on domestic growth or an increase in prices. So far, few companies have factored in material changes to their earnings guidance due to the outbreak. It will be important to continue to monitor earnings calls to better understand the expected impact.

So how should you react from an investment standpoint? As with other black swan events, the whole market tends to sell off dramatically regardless of the actual economic impact to specific companies. This can create some great buying opportunities once the dust settles.  It is a great time to identify sectors or individual companies with little or no exposure to China or the Chinese supply chain. This should be relatively easy as it will be a similar list to the sectors we identified during trade negotiations over the past two years.  I am not saying you should rush out and start buying hand over fist, but as we get some clarity on the containment and treatment of the virus these will be the first companies and sectors to bounce back, especially with many of them announcing earnings over the past week or two.

Strategy Commentary

I continue to maintain the same overall exposure to equity.  Even with fears that the Coronavirus could slow global growth, especially in Asia, I think any damage will be short-lived. I also think the spillover to the US will be minimal. With earnings continuing to be strong I think the pullback near the end of the month was a great long-term buying opportunity.  I already had a slightly overweight equity exposure so I did not have any free cash to add to my positions, but had I still been underweight equity I would have added.

Domestically, I continue to maintain my overweight to Technology.  While the sector continues to outperform, earnings continue to prove that there is more room to the upside.  I am still overweight financials based on some good earnings results but with rates dropping sharply last month this could put some pressure on some of their lending operations.  I have trimmed my industrials exposure and added a little to utilities.  Utilities have been an outperformer for the past year, and I think they continue to represent a good hedge if Coronavirus impact increases or we see and other shocks to the system.

I have adjusted my international outlook, especially in Asia, due to the Coronavirus.  While I think the economic damage will be very short-lived. The increased risk doesn’t justify the potential return.  We may look back and see this recent pullback as a great buying opportunity in Asian stocks, but I think there are less risky places to put that money to work.  With that said, I reduced my exposure to Japan.  In the long run, I still am bullish on China but will wait till we see some progress on the virus before adding back to any positions.

I have not adjusted my fixed income allocation but with the drop we have seen in yields over the past month we could be close to a reversal.  The Fed continues to be predictable and without any other black swan shocks, I think rates will probably stabilize back to the range they were in over the past 4 months.