This morning we have seen the markets react negatively to the drop in oil prices; last week, fear was driven by central bank action and this all started with concerns over the impact from coronavirus. At times like this, advisers tend to run to ground; looking back over the last 10 years, our blogs tend to increase during periods of uncertainty.

Over the last couple of weeks, I have put together a blog on the potential effects of the coronavirus, and Paul wrote on the recent sharp declines in stock markets.

We have never had any ability to predict the outcomes of markets over short periods. In this blog, we will examine what outcomes could arise.

Risk vs volatility

There is a great deal of focus on risk, and this can be misleading. Risk is the permanent loss of capital. The best story to demonstrate the difference would be if we invested £50,000, went away for 10 years with no access to market information, came back and the investment was worth £100,000.

We would likely be quite pleased. During that period the investment could have been worth £30,000 or perhaps £120,000 at any given point; knowing this might change our view but this is volatility and is the movement in the value from one day to the next.

If we monitor our investments daily it can be very uncomfortable, but seeing where we started and where we end up over a long period of time, paints a very different picture.

There are many studies which show that staying invested in the market, however uncomfortable this might be, is often the best thing to do. Legg Mason recently published a paper showing being invested every day in the US market from 1930 to today, would have delivered 6% p.a. Missing out on the ten best days during this period would have delivered 1% p.a.

Nobody likes uncertainty

It is just over ten years since we had our last global recession. The journey from 2008 until 2020 has not been smooth. 2011 saw the European Crisis, 2015 saw significant falls in China and this spread globally, 2016 was a continuation of 2015, and then we had 2018. This is the third time we have seen markets drop by over 20% since 2008.

Before the start of this week, the S&P 500 had dropped by 13% from its historic high in February. Additionally, we have seen US treasuries drop significantly and interest rates have been cut by 0.5% with expectations of two more rate cuts.

The correction is the fastest decline in the history of markets so what does this all mean? The big question is whether the global economy is on the tip of a recession and how soon will it recover?

There are many indicators of a global recession and economists have differing views. There are a few things we do know; normally before a recession there is exuberance in the markets, and over leverage by consumers and businesses. We are not seeing this now. A recession is defined as 2 consecutive quarters of negative GDP; the economy shrinks in real terms. However, if this is caused by a short term shock which reduces activity, which subsequently restarts and recaptures deferred growth, then this could be seen merely as a blip and non-structural. If the first 2 quarters of a year are -1% and another -1% then +3% and another +3% in the second half of the year, you have a net positive GDP result of +4%, which was your projection at the beginning of the year. This could easily be the case here and has been in previous pandemic events.

What next

The economic data filtering through is not positive. In the US the profit margins in micro and small-cap companies are being squeezed and this is where most people work. There are concerns that if this continues then companies may cut back on hours, and then jobs. This is not happening yet, but is something that needs to be watched.

Chinese PMI data (manufacturing) is down to 35.7%, the markets were expecting 45%. If you factor in small companies, this drops to 26.75%. In theory this could see GDP drop into negative territory. There are also concerns that workers are not going back to work as quickly as is being reported.

In Italy, a shut down in schools, universities and the lack of tourists will clearly impact the economy for a time. If we see other economies (including the US) impose travel restrictions and cancel events, then this will hurt growth. There is evidence from the US that people are stock piling goods, and that there is a slippage in entertainment as people avoid crowded spaces.

It is therefore a fair assessment to say that we can expect growth to slow and this has the potential to cause a global recession. Equally, it is possible for economies to recover just as quickly.

Holding our nerve

The central bank in the US has moved quickly to show it will do whatever it takes. This caused concerns with markets. Legg Mason argued this might be a shrewd move. Often central banks react when everything is falling apart and then it takes time for those actions to feed through into the economy.

By reacting now, the thought is that this could feed into the market just at the time it is most needed.

Secondly, at some point coronavirus will peak and then decline.

This is taken from Washington Post but is important: China is the origin of the virus and still accounts for 80% of cases and deaths. Its cases peaked and began to decline at the start of February.

According to the Washington Post subsequent countries will follow this same pattern, in what’s called Farr’s Law. First formulated in 1840 and ignored in ­every epidemic hysteria since, the law states that epidemics tend to rise and fall in a roughly symmetrical pattern or bell-shaped curve. AIDS, SARS, Ebola — they all followed that pattern, as does seasonal flu each year.

It also seems that like most viruses, this one doesn’t like warm and moist weather and therefore, there would seem to be a natural inflection point.

This, potentially, is important, tied in with the lack of over exuberance and leverage within economies. Legg Mason believe that if we do have a recession it could be a short and shallow with a strong bounce. The reason being that if coronavirus is the catalyst that brings about a global recession; then at the point the cases peak and decline globally people will start to go out again and spend. This means that although the falls might seem dramatic, but the bounce back could be equally fast and furious according the Legg Mason.

What we know

We know that the markets are likely to be very choppy over the coming weeks, and fear will play a big part in this. We also know that global growth will slow as countries impose travel restrictions, and people avoid spending especially in entertainment.

If Farr’s Law is a good measure, then we will see a rapid rise in cases and then fall, in line with China. As we come into warmer weather, in theory, this should slow the number of cases. As this happens then we should see travel restrictions lifted, and people starting to feel confident to move freely again. What we don’t know is whether the coronavirus is the catalyst which drives the global economy into a recession.

But it is worth remembering we have seen three 20% declines since 2008, and each time markets have recovered. It is also worth adding that with low levels of leverage and a lack of exuberance within the markets, it could mean that the recovery is very sharp and swift.

Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.