3/5/2020

COVID-19 update #1 , 3/5/2020 - Thoughts on the economic effects of coronavirus in light of heightened market volatility:

1) Economic effects of coronavirus thus far:

In its attempt to contain coronavirus, the Chinese government took unprecedented actions this year that, as a side effect, have caused the Chinese economy to contract meaningfully. For example, in February 2020 China's manufacturing and services purchasing managers indices (PMIs), respectively, signaled record and near-record economic contraction (link). 

This is relevant from a global economic perspective because China is the world's largest manufacturing economy (link) and, as such, pauses in Chinese economic activity can create supply chain bottlenecks that reduce manufacturing output and profits worldwide. For example, a US automaker may not be able to produce cars without components from Chinese suppliers.

In terms of the US, in addition to the negative Chinese supply chain effect coronavirus fears are also dampening consumer demand for travel and leisure services. Although the US has had relatively few coronavirus cases thus far, the exponential nature of the virus's growth means that this can change rapidly, and caution is already ubiquitous (try buying hand sanitizer right now...).

On the positive side, this virus's dampening effect on commodity prices and interest rates helps US consumers, all else equal, because lower commodity prices and rates reduce Americans' everyday expenses, and recall that approximately 2/3 of US GDP is driven by consumers (link). Now is absolutely an above-average time to consider refinancing one’s mortgage.

Overall, we stand by the top-down economic points we made in our 2019 year-end letter. Namely, Long Game Financial (“LGF”) believes that both US consumers and the US housing market continue to be well-situated prospectively, and we think that it is tough to envision a nasty US recession if US housing is ok. If anything, lower interest rates and commodity prices help US housing because they increase home affordability and decrease building costs.

2) Stock market effects of coronavirus thus far:

As far as US financial markets as concerned, as I write the S&P 500 is down -6.7% year-to-date for 2020 (link). 10-year US treasury bonds are yielding a record low of 0.93% (link). The CBOE Volatility Index—the most widely reported gauge of market uncertainty—is 36, which is more-or-less as high as the VIX tends to get (link).

During times of market volatility it is important to keep in mind that the stock market is not a monolith but, rather, an amalgam of sectors and companies. This means that when something like coronavirus comes along one should consider its effects on the market's individual components one-at-a-time because certain industries and geographies will invariably feel more economic pain than others.

Below is a visualization of the return of the S&P 500's components from 1/1/20 through 3/5/20 (source: finviz.com) that illustrates just this: so far in 2020, energy stocks, large-cap banks, travel stocks (e.g., airlines and resorts), and anything with a global supply chain (e.g., pharma, autos, and some tech hardware companies) have disproportionately dragged down the market average.

That these particular groups have underperformed the market makes sense because commodities, travel demand, and global supply chains have been ground zero for coronavirus's economic effects. Many banks, in turn, have credit and market exposure to these groups and non-US economies like China alike, and over time record-low long-term interest rates are bad for bank profits.

We note that most of the stocks that have underperformed this year lack the resilient qualities that LGF prizes. For example, oil companies by definition have no control over the price at which they sell their product, and profits for cyclical, high incremental margin, and high fixed cost businesses like airlines and hotels are extremely sensitive to capacity utilization. Businesses like these are poorly-equipped for a sustained, global pandemic scenario.

Meanwhile, the areas of the stock market that have outperformed the market average thus far in 2020 include software, internet, and real estate. These groups have limited exposure to the virus's effects and in certain cases may even benefit from the virus's effects. For example, all else equal lower interest rates help the real estate investment trusts that LGF clients own.

As it happens, software, internet, and real estate are the general areas of the stock market in which LGF predominantly invests—currently, and for the foreseeable future—for reasons discussed in prior letters. These reasons include LGF's CAM and Four-Step Pattern investing frameworks as well as our long-standing macroeconomic caution towards China.

To echo the LGF’s investment frameworks within the context of power laws section of our 2019 letter, although no one could have predicted coronavirus, we can estimate business resilience—and we argue that LGF's focus on business resilience is helping us at present and will continue to help us in the future.

© 2020 Long Game Financial, LLC