Coronavirus’ impact on share markets is a hot topic at the moment. We’ve seen global markets fall by over 10% between 21 February and 2 March 2020. It seems that the market’s sentiment shifted literally overnight from a state of being arguably ‘over-optimistic’ to being ‘very fearful’. Some of my clients have voiced their concerns about the impact that coronavirus might have on their investments. I wanted to share my thoughts on this and what actions, if any, you might take.
The share market can be a wild ride, you just need close your eyes and hang on
When the market is running hot, most investors overestimate their tolerance for risk (volatility). Often people say, “I understand that share markets can be volatile, and I’m prepared for it, let’s invest”. However, when the volatility does eventually occur, that is when you really learn about one’s appetite for risk.
We must realise that volatility is often short lived. Share markets have a volatility rate of circa 20% p.a. This means, annual returns can vary from the mean (average) return by +/- 20% from year to year. However, in the long run, there’s a strong trend of mean revision – which means investment returns in the long run are more predictable. The chart below provided by global fund manager, Dimensional demonstrates this. Market returns 5 years after a major event (e.g. crashes, terrorist attack, CGF) are positive.
And realise that you have to be in it to win it
In the face of uncertainty (i.e. higher volatility), some investors consider selling. The problems with selling is that you will likely miss the recovery. The chart below (again courtesy of Dimensional) demonstrates that your investment return between 2001 and 2018 (more than 4,300 trading days) would reduce from 7.66% p.a. to 1.76% p.a. if you missed the best 25 days over that period. In this case, you would have been better off investing in bonds, not equities.
This proves that you need to remain invested throughout good times and bad. The first rule of investing in my book Investopoly, is to ‘play the long game’. If you applied this approach when you first invested in the share market (i.e. a diversified portfolio of low-cost, rules-based investments contructed to maximise long term returns), then you must have faith that it will work. And it will, if you’ve done it correctly.
The practical impact of the coronavirus
It would appear that the coronavirus is essentially a highly contagious form of influenza. Therefore, as long as you are in good health, its unlikely to be life threatening and mortality rates will remain contained. As such, I think the biggest impact that the virus will have is that it will adversely impact the mobility of people. For example, people will reduce or eliminate discretionary travel, they may curtail shopping and social activities and, in some circumstances (e.g. in China), businesses may cease trading because workers cannot (or are unwilling) travel to work.
This will most likely have a negative impact on economic growth in at least the first half of 2020, although growth is likely to still be positive. China has a much bigger economic footprint than it did in 2003 during the SARS outbreak, as depicted in the chart below (provided by Fidelity). Australia exports a large amount of natural resources to China. Demand for these might reduce temporarily. However, the good news is that stockpiles (inventories) are relatively low and the Chinese government may have to deploy fiscal stimulus (increase government spending) which should underpin the demand for Australian resources in the medium term.
Company earnings growth has recently been relatively robust, but no doubt will be negatively impacted. Obviously, some industries will be impacted to a greater extent than others, such as manufacturing and international travel (especially cruise line operators for example). But some sectors such as healthcare and domestic tourism may actually be benefactors.
Vested interest in the US share market continuing to do well
The US share market accounts for approximately 63% of global developed markets (MSCI Index) and is typically the leading indicator for other markets. That is, if the US falls by 3%, most markets will follow. This is true in the short term, but less so in the long run (long term performance eventually decouples from the US).
President Trump has taken full credit for the state of the US economy and its share market being at record highs (prior to the recent dip). I believe that if the economy and share market continue to remain healthy, the chances of him getting re-elected for a second term in November 2020 are high. However, if the share market or economy were to falter, re-election is less certain. Therefore, I think Trump will do whatever he can to ensure the market remains buoyant and the Federal Reserve is certainly helping him through quantitative easing (it has injected $77 billion per month – way more than it did during the GFC!!). And over the weekend, Trump was bullying the Fed on Twitter to cut rates.
The average US share market return during an election year is 11.3% p.a. since 1928.
Government fiscal stimulus to offset economic impact
ANZ Research is predicting that the Australian government will need to provide fiscal stimulus to offset the economic impact that the coronavirus might have. This could include providing loans or grants to business, to avoid them laying off workers. This can be targeted towards the most affected sectors/industries. State governments can also play a role through easing taxation burdens (e.g. Queensland is allowing small business to defer payroll tax obligations for 6 months).
The market bounce and future volatility
The US market recovered sharply on Monday 2 March by rising approximately 4.5%. As I write this blog, our market is up by nearly 2%.
The market has been relatively blind to risk over the past few years. Share market valuation have irrationally continued to climb irrespective of economic or geopolitical risks. I disbelieve that markets have materially changed this approach. I don’t think that the market has suddenly decided to become rational about risk. The best example of this is that most brokers haven’t made any changes to forward earnings estimates to account for the coronavirus impact. Therefore, I think the falls over the past week have been the result of momentum selling rather than a rational response to risk. As such, its very possible that the market will fully recover over the next few weeks or months.
Could be a good investment opportunity
If you have already invested monies in the share market, then my advice is to hang in there and ride out the volatility.
However, if you have surplus monies that you planned to invest at some stage then you may be able use this recent volatility to your advantage. The problem is that no one knows what markets will do in the short term. No one on this planet has developed a consistently accurate methodology for predicting short term share market movements. As such, we will never know the “best” time to buy i.e. the bottom of the market. Therefore, the most prudent approach is to regularly invest in small tranches e.g. every few weeks or months. This will diversify your timing risk. If the market continues to fall, you will reduce your average entry price. If the market recovers from here, you’ll make money. Whilst this approach might seem unsophisticated, I’m not aware of a superior (lower risk) approach.
There’s safety in methodology
One of the common themes from hundreds of share market performance studies is the simple concept of diversification. That is, if you have a large amount of diversification (in terms of holdings, geography, sector/industry, investment style and so on), you will generate good investment returns in the long run.
Therefore, if you have adopted the right approach, you have absolutely nothing to worry about. All you need to do is put your faith in the evidenced-based methodology that you have adopted. However, if you aren’t confident with your chosen investment approach/methodology, then this could be a good wakeup call. And if you need our assistance with working out a way forward, don’t hesitate to reach out to me for a confidential chat.