Showing great journalistic foresight, my friends at the Australian Financial Review asked early last week if I would mind making my regular monthly column about the CoronaVirus rather than the previously agreed topic. This I duly did, here. Of course all the press this weekend was on this topic!. Unfortunately the site is behind a paywall, so I include the (unedited by them) text below to give a flavour of the commentary. I don’t claim any great medical insight (actually a point I make about instant experts), but rather highlight the playbook that markets tend to follow when uncertainty spikes.
AFR January 26th 2020
It is often said that markets don’t like uncertainty. This is not strictly true, for while long term investors are seeking to match asset and liabilities and to price actuarial risks and thus are largely indifferent to noise and uncertainty, it could be said that short term markets exist precisely because there is uncertainty and they are there to help the medium term asset allocator reduce their risk exposure in response to rising uncertainty. The uncertainty may be a threat of nuclear war, a collapse in global trade, a conflagration in the middle east or the breakup of a major trading bloc, to name only a few that occurred in the last eighteen months, but the response tends to follow a similar pattern. The first stage in response to an increase in uncertainty is one of de-risking by the asset allocator, which means taking down leverage in portfolios and generally reducing beta, selling cyclicals and buying defensives, reducing equities and buying bonds. At the same time any outlying ‘bets’ against the benchmark, either overweight or underweight, tend to get flattened, which sometimes leads to apparently strange buying patterns. This type of response is both behavioural and commercial; in the first instance an increase in uncertainty prompts a feeling of a need ‘to do something’, particularly among so called active investors, while commercially it is important to reduce business risk by flattening bets against the benchmark. To follow Keynes’ dictum, it is better to fail conventionally and go down in line with the markets rather than stick to a conviction position and underperform both the benchmark and the peer group. That way lies redemptions.
The second stage is often an attempt by shorter term traders to make money from the situation as it unfolds. It is both amazing and amusing to observe how quickly market traders can become experts on all aspects of the new uncertainty, similar to the rapid acquisition of expert knowledge about minor Olympic sports during the televised games. This has only become enhanced thanks to the internet and social media, which together with more traditional media acts to rapidly spread these new ideas and theories.
We began the year expecting uncertainty over Brexit to be declining and uncertainty over US politics to be rising, only to be hit, briefly, with the threat of war with Iran. A threat that thankfully seems to have receded. For now. Barely a week later and ahead of the huge movement of people that is associated with the Chinese New Year, we have a new uncertainty with a SARS like threat emerging from China and Asian markets in particular have reacted sharply. The Coronavirus is obviously a classic example of a new uncertainty (now with 278 million results on a simple one word google search) and the market has already responded in line with stage 1, with Chinese markets down over 5% and Hong Kong, with painful memories of SARS and bruised by the events of last year seeing higher than usual levels of paranoia. It is difficult to say how much further they can go, but by observing that not only is there an awful lot of profit from last year in Chinese Equities still to be taken, but also that the expected rotation into China this year by international investors will almost certainly have been put on hold, it would be foolish to call a turn right here. In terms of what our instant experts can tell us, we know that several Chinese cities in addition to Wuhan have been placed on lockdown and that cases have been reported all over Asia and now in the US.
Commodities and currencies of course are the main short term noise markets and as far as markets are concerned, after the initial phase of deleveraging and de-risking by equity and credit markets, it is traders here who are trying to come up with some new narratives. The most obvious is an economic slowdown, with the natural benchmark being the SARS outbreak from 2002. Even though this was relatively short lived and contained quite rapidly, it nevertheless devastated trading stocks and particularly Hong Kong housing markets. Oil and copper have already been hit on this basis, with commentators caught between praising the Chinese authorities for acting quickly – in contrast to SARS – and thinking that this must mean it is even worse than they are saying. Part of the problem with the SARS comparison for equities is that global stocks were coming off lows at the time, rather than highs as they are now. Regardless of aggregate valuations, at the sector level, the obvious candidates, like travel and casino stocks, have been the most visible casualties so far, while healthcare and related stocks have been the winners. The experience from SARS and other infectious disease outbreaks is that the uncertainty risk premium rises with the number of cases and only starts to unwind when the rate of growth of cases starts to slow. As such, we would expect this uncertainty premium to persist for a while yet and investors need to decide in which section of the markets they stand. For long term investors, there is nothing to have been done, nor does there yet seem anything to do. For medium term asset allocators, it is likely that phase one is now already in prices and the decision/pressure now is whether or not to buy into the short-term traders’ narrative about how to ‘play’ the uncertainty. History suggests that abandoning existing strategies to chase new, narrative driven thematics is a dangerous path to follow. With little prospect of clarity until after the lunar new year and with many Asian markets closed, the best advice is probably to watch and wait.