In our opinion, the recent pickup in market volatility is a reaction to a combination of the unknowns associated with the COVID-19 coronavirus, namely its impact on the global economy, Bernie Sanders’ surge to frontrunner status in the Democratic polls, deleveraging and algorithmic trading that can exacerbate short-term market volatility. In addition, after a strong 2019 for equities and a fast start to this year, the market appears ready to consolidate some of those gains, which would be normal. In the short term, investors have reacted by seeking a higher margin of safety, which has pushed Treasury yields to the lows of the year and, for some parts of the yield curve, has pushed yields to all-time lows. For example, the 30-year Treasury yield at 1.66% is at an all-time low. The current 10-year Treasury yield at 1.14% is also at an all-time low. Interestingly, by comparison, the market, as measured by the S&P 500 now carries a 2.0% forward dividend yield or almost twice that of the 10-year, despite equities’ long-term prospects for growth.
Despite the near-term discomfort, it is important to remain focused on long-term objectives and assess the probability that any of today’s “wall of worry” items will have a material impact on the value of high-quality assets five, ten or even fifteen years from now. In the short-term they could, and we remind investors that a low double-digit percentage correction is the norm in most years. However, over an extended period, the value of equities regresses to a combination of long-term earnings power and prevailing interest rates. On that front, the interest rate outlook remains, in our opinion, low for longer with additional FED support likely if necessary, which could calm markets.
Regarding long-term earnings power, supply chains that are being disrupted today can be re-positioned for greater diversification, resilience and corporate strength in the future. Temporarily lost sales will force companies to become more efficient and to seek new markets and relationships for their goods and services. Health sciences companies can show the world their technological capabilities in response to the outbreak. In terms of global health policy, cooperation between global agencies will create new engagements to foster best practices that will make future health outbreaks potentially less severe. In other words, policy response and corporate strategy are dynamic, not static, and the uncertainty that periods like this create are the very seeds of innovation and corporate evolution that will lead to greater economic and market highs at some point in the future.
In terms of the coronavirus, there are still “unknown unknowns” at this point about the scope and severity of the outbreak that are contributing to market uncertainty. The length of the incubation period makes handicapping the virus’ spread, the effectiveness of quarantining and the resulting impact on the global economy difficult to anticipate. As the chart from a recent MarketWatch article shows, the long-term impact of global health outbreaks tends to fade as treatment, cooperation and confinement eventually stem the tide. However, temporary economic disruption is also a byproduct of that process.
In terms of the potential Sanders nomination and the stated policy agenda that the market has so much angst over, from our viewpoint, the numbers are challenging as it appears Democrats will need a candidate that unites every facet of the party in order to gather the votes to unseat an incumbent President who scores well with voters on the strength and handling of the economy. But, never say never, as the chance of an upset, especially if the virus outbreak lingers, should keep the market on its toes for most of the year.
In closing, as an investor, market participation comes with periods of uncertainty. It is simply the other side of the handshake with return. In our view, asset allocation remains the first and best line of defense in managing risk. While no one likes to invest at such low yields, weeks like this remind us why it can be important to maintain a well-diversified portfolio that includes fixed income. We view fixed income investments as a ballast in a portfolio that helps offset exogenous shocks in the equity market, helping to lower overall volatility in portfolios. Alternative investments, especially strategies that hedge, contribute to portfolio diversification and resiliency as well. It is easy to get complacent about asset allocation in a bull market, but periodic flare-ups and the unpredictable events that cause them are a reminder of the importance of the three investor tenants we emphasize so consistently: diversification, quality and time.
If we can review any aspect of your portfolio in the current environment, including held-away assets you would like to incorporate into your overall asset allocation picture, please do not hesitate to reach out for further analysis and discussion.