Update #2: Coronavirus, the Economy, and Your Investment Portfolio

ALL POSTS PRIOR TO 2021 HAVE NOT BEEN REVIEWED NOR APPROVED BY ANY FIRM OR INSTITUTION, AND REFLECT ONLY THE PERSONAL VIEWS OF THE AUTHOR.

A 2nd Special Update from Scholar Financial

Tuesday, March 10, 2020

By Ron A. Rhoades

The fears from the coronavirus and its potential economic impacts continue to impact the capital markets. In this update, I’ll seek to provide you with some information on the effect of the capital markets on the economy and the capital markets, and some perspective about your investment portfolio’s strategy as it is impacted by recent developments.

Here’s some data on the capital markets, as of today:

• The U.S. Treasury 30-year bond, as I write this, yields only 1.09% - and it had fallen below 1% for the first time since 1950 just yesterday.
• The U.S. Treasury 10-year note yields only 0.634% currently - near its record low of 0.55% yesterday, and far below prior historical levels.
• The U.S. Treasury 1-month bill is yielding a relatively high (compared to longer-term notes/bonds) 0.587%.
• U.S. stocks have fallen 15-20% from their highs on Feb. 19th - just a few weeks ago.
• European stocks (as measured by STOXX Europe 600 Index) are down 23% from their Feb. 19, 2020 high.
• Global stocks (which includes the U.S.) are down 20% from their high on Feb. 20th.
• Stocks in India, as measured by the S&P BSE Sensex Index, are down about 16% from their highs on January 17, 2020.
• But … stocks in China (per the Shanghai Composite Index) are now only down about 4% from the value of the index seen on January 13, 2020, and these stocks are up 9% from their recent lows.

What does the future hold? – The Coronovirus and Its Containment or Mitigation. 

Certain countries, including Italy, South Korea and Iran, have been hit very hard by the coronavirus. Italy has over 9,000 cases, and South Korea over 7,500. By comparison, Germany and France are each reporting over 1,000 cases. The United States, as of early today, had 566 reported cases.

The number of reported cases is likely far below the actual number of cases. Since many of those who have the coronavirus don’t possess any symptoms at all, or have only mild symptoms, it is likely that there are far more persons in the world today than the globally reported number (113,000 infections globally, or which 81,000 are in China).

The future here in the U.S. all depends on whether the coronavirus can be contained, and how fast such might occur. It is also dependent (less so) on fiscal and monetary stimulus efforts.

What’s clear is we face an easily transmitted, flu-like virus. However, it’s more dangerous than the normal seasonal flu, particularly to the elderly and people with other health conditions. And it continues to spread, in the U.S. and other countries.

But, with greater testing becoming available in the U.S., and quarantine procedures being put in place in some locations, can we contain the spread?

In the U.S., 43% of workers worked remotely at least some of the time. That number is likely to be larger in the coming weeks.

Major universities such as Vanderbilt (one hour south of Ron & Cathy’s home), Ohio State, University of Washington, University of Southern California, and others have announced they are moving to online classes (for several weeks, or longer). 

If the experience in China is any clue, the coronavirus can be contained to some regions of the country. But to do so may mean accepting quarantines for entire towns and cities. Daily health checks upon arriving at work are performed by some employers. Accepting questions about one’s recent travel history may become far more commonplace.

But “containment” is too late, for some areas of the U.S. In the early stages of an outbreak when the number of cases is small, health officials can focus on tracking down and isolating individual cases. It’s akin to stomping out a few embers that have jumped from a fire. The failure of the United States to quickly roll out tests for the virus impeded the U.S.’s early efforts at containment. Because of flaws with the original CDC tests, it took weeks for state and local labs to get working tests for the virus, hobbling their attempts to identify patients and isolate them.

“Mitigation” occurs in areas of the country where containment has failed. This basically means canceling large gatherings (including sports matches), closing schools and universities, and asking employers to let as many as possible work from home. Hospital beds are “repurposed” away from elective surgery to handle the increased cases from the coronavirus.

While some 70% or more of retail stores and factories in the affected areas of China have opened, restaurants and hotels remain largely closed, and few travel between cities or regions. Airlines are cancelling flights, as demand for air travel plummets. Some factories remain closed.

So, in essence, the impact of the coronavirus here in the U.S. will vary. Many of those who work with information – i.e., office jobs, teaching jobs, and related types of jobs – will adjust by working at home. Some factories may be closed for a period of time. Many retail stores will remain open, in order to fulfill the need to deliver goods (especially food, other necessaries). But many other low-wage employees will be laid off, at least temporarily. While larger companies may compensate laid-off employees, many smaller ones will not have that financial ability.

Will U.S. citizens accept restrictions on movement, and increased monitoring of their personal health? For example, New York Governor Cuomo just deployed, today, the New York National Guard to establish a “containment zone.” I suspect the vast majority will. But there will be a difficult balancing between “civil rights” and “protecting public health.”

The U.S. Government Reaction

The Federal Reserve took the rare move to lower its benchmark target short-term rate by 0.5% just last week, to a new target range of 1% to 1.25%. This was the deepest cut in rates since the 2008-9 financial crisis.

Many observers are predicting that the Federal Reserve will cut rates another 0.5% at its meeting on March 17-18. Another cut could follow in April, by another 0.5%. It is possible that the Federal Reserve could cut its target rate to zero.

Other central banks around the world are largely cutting interest rates, as well. We have seen negative yields in several European countries over the past several years. Now, negative yields for sovereign short-term debt exist in: Austria, Belgium, France, Germany, Ireland, Italy, Netherlands, Portugal, Spain, and Switzerland. 

In addition, the Federal Reserve is providing more cash for overnight needs of banks, to guard against shortages in the money market (very short-term, highly rated debt market).

Lowering interest rates and, in many countries, purchasing bonds by governments (known as “quantitative easing”), is known as “fiscal stimulus.” But the actions of central banks will not be enough to stop a global economic decline.

In the U.S., fiscal stimulus is now being considered, in the form of tax cuts (perhaps to the payroll tax, for a limited period of time) or greater federal government spending, or both. The move to embrace some form of fiscal stimulus is far from certain, given the current state of politics in Washington, D.C. Also, some in the government view the coronavirus impacts as very short-term (i.e., only lasting a few months), while others see the coronavirus threat lasting into early 2021, and possibly later.

The Reaction of the Capital Markets

The market is clearly responding to new information as it becomes known, but the market is pricing in unknowns, too. As risk increases during a time of heightened uncertainty, so do the returns investors demand for bearing that risk, which pushes prices lower.

Bearing today’s risk, in investing, will be compensated with positive expected returns. That’s been a lesson of past health crises, such as the Ebola and swine-flu outbreaks earlier this century, and of market disruptions, such as the global financial crisis of 2008–2009. Additionally, history has shown no reliable way to identify a market peak or bottom.

If stock market values fall further, higher expected returns result. This is tempered a bit by the fact that the global economy falls 

The best approach is, and remains, strategic asset allocation combined with rebalancing the portfolio. For example, if the stock market goes down very significantly, and your portfolio gets substantially out of balance, that’s a time for buying stocks.

In other words, as I teach my students: “Buy low, sell high.” Of course, we don’t know - when we buy - if the market will continue to go lower. Positive or negative news about the coronavirus, and the economy general, will emerge that affects subsequent price changes.

Valuation Levels and Investing.

Before the coronavirus health crisis emerged, U.S. stocks – overall – were very overvalued. Despite falling nearly 20% in price, the significant overvaluation remains for U.S. stocks, especially growth stocks.

But not all asset classes here in the United States are overvalued. The following chart sets forth the range of overvaluations / undervaluations for six different U.S. stock asset classes:

(Data as of close of trading, Monday, March 9, 2020.)

ASSET CLASS	Range of Over-Valuation or Under-Valuation	Expected Average Annual Returns Over Next 15 Years
U.S. Large Cap Growth Stocks	50% to 90% overvalued	2.1%
U.S. Large Cap “Balanced” Stocks	10% to 35% overvalued	5.7%
U.S. Large Cap Value Stocks	Fairly valued to 20% overvalued	7.2%
U.S. Small Cap  Growth Stocks	10% to 25% overvalued	4.4%
U.S. Small Cap “Balanced” Stocks	10% undervalued to 5% overvalued	10.1%
U.S. Small Cap Value Stocks	20% undervalued to fairly valued	10.8%

Based upon proprietary analysis undertaken by Ron A. Rhoades, using historic and current P/B ratios of various Russell indices, with further adjustments made to future expected average returns due to lower expected inflation rates, lower economic growth (due in large part to slowing population growth), and lesser additional returns expected from various factors. These are estimates of overvaluation/undervaluation, and estimates of future average long-term returns, only. RETURNS ARE NOT GUARANTEED. Past performance is not a guarantee of future results.

As seen, U.S. small cap value stocks possess a much higher expected average annualized return, over the next 15 years, than most other U.S. stock asset classes shown.

There is greater uncertainty about the returns of foreign stocks. The U.S. dollar has weakened slightly against many foreign currencies (due to the lowering of interest rates in the U.S.), making it a bit more expensive at present to purchase foreign stocks. Also, the abilities of foreign developed markets countries and foreign emerging markets countries to contain the coronavirus, or to successfully mitigate its impact, varies widely. For this reason, I’m not providing projections of foreign stock returns, at present. While foreign developed markets appear reasonably valued, and foreign emerging markets appear slightly undervalued, at present, there exists in many countries far greater uncertainty about the potential impact of the coronavirus upon the economy (and, hence, the capital markets, or valuation levels).

Conclusions?

Stock values around the world have largely fallen. They could fall further, or they could begin to rebound. This depends, largely, upon efforts to “contain” and “mitigate” the coronavirus outbreak. And the success of these efforts is largely uncertain, and will vary by country (and even by regions, within countries).

What can be said is that U.S. stock market valuations are, overall, high. While U.S. small cap value stocks are somewhat undervalued at present (or at least fairly valued), I would not rate this as a significant buying opportunity.

For fixed income investments, there is little reward for taking on the greater risks present in holding longer-maturity bonds, given the very “flat” “yield curve.” In addition, there exists very little advantage to holding bonds of lower credit quality. Very short-term CDs are yielding a bit more than U.S. Treasury short-term notes, and may be favored in some portfolios.

We should adhere to the discipline. I will continue to monitor your portfolios, and if and when actions – such as rebalancing - should be taken, I will contact you.

In the meantime, feel free to contact me should you have any questions.

Thank you.

Ron A. Rhoades, JD, CFP®

Scholar Financial