Knowledge. Shared Blog

February 2020

Can Equity Markets Recover from the Coronavirus?

As the coronavirus spreads, stock markets globally have declined on falling earnings expectations. But as Director of Research Carmel Wellso explains, these types of market shocks tend to be short term in nature and can lead to a strong rebound.

Key Takeaways

  • After weeks of strong performance, markets have started to factor in potentially lower earnings for the first half of 2020 due to the spreading coronavirus.
  • Historically, such outbreaks have resulted in three economic stages: demand weakness, supply-chain disruption and permanent behavioral change. Currently, we believe we are in the second stage.
  • During the SARS outbreak in 2003, stocks rebounded strongly following the market’s sell-off. As active managers, we can analyze companies to try to determine where the impact could be most severe and which companies might recover quickly.

View Transcript

Carmel Wellso: I think part of the reason the market is reacting so strongly right now is that we had such strong performance coming into this, particularly in the U.S., the tech sector and a few other higher-growth sectors. And as a result, you’ve got the potential that you’re not going to have as high earnings, so those multiples are starting to look even more stretched than they may have before. What changed this week would be that we’re starting to see it [the coronavirus] spreading to other markets, and once you start to see that more multiple-country impact, then people get more worried.

I think the market approaches these types of viruses in three different stages, and this is based on more what happened with SARS [severe acute respiratory syndrome]. The first stage is, what are the demand weaknesses? So, people don’t want to go to restaurants, they don’t want to go to hotels, they don’t want to get on airplanes, and those [companies] immediately start to see some impacts with a drop in their forward bookings, so we get the downgrades from those.

The second stage is the supply-chain issues. So, that’s where I think we are in terms of the development of the market, where suddenly this was contained to China and you don’t want to own a restaurant chain in China. And now suddenly it’s, oh, the factories are going to be shut for another two weeks, or they’re operating well below their capacity and, as a result, the factories in the U.S. or in Europe that are exposed to those markets are actually going to have not enough supplies to generate the kind of output they like to generate.

And then the third stage is, what behavior is changing permanently? That’s going to be the interesting one because if you have an octogenarian in China that is suddenly ordering their food online and they realize, this is really handy, we might get to see some changes from that. And that’s the longer-term impact, but I think we’re in that second stage at this point.

I think there’s probably more downside potential in certain pockets of the markets. I do believe that people are underestimating the impact on some of the European exporters. I do believe they’re underestimating some of the impact on the tech sectors, which get a lot of their supplies from China and Asia, in general. And that’s where we’re probably going to see more downside to the earnings. Now typically, these markets expect these changes and they react before we see the downgrades – and I’m thinking about second quarter downgrades at this stage, as opposed to just first quarter – but we haven’t, I don’t think we’ve hit the bottom yet. I think there’s still a little bit more downside.

But to put it in perspective, from the time SARS started to the time the Hang Seng Index troughed, that was only a 15% downside. In the time from the trough to the end of the year – so from July [2003] to the end of the year – that was up 50%. So, the market knows that when people panic there are opportunities, and so we may not get as much downside in the valuations or in the stocks as you would expect with the sharp declines in earnings we’ll see over the next two quarters.

I think the key thing is to look through these issues. Most viruses are short term in nature; they’re the flu season; they’re from November to summer. And there will be a point at which not only the second derivative is improving but there are going to be very few new cases and that typically only lasts less than a year. If you think about demand, it’s been pushed back, it hasn’t disappeared. We have our sector specialists and they’re constantly looking at these companies trying to determine where the shocks are going to hit the hardest and where the companies are going to recover the fastest. And I think that’s one of the benefits of active management, that we can pick stocks during a cycle like this. I would expect the market to come roaring back at some stage. I just can’t tell you when.

 

The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong.

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