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Investment Implications of COVID-19: Worse Before Better

February 27, 2020 | Multi-Asset

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When we began discussing the coronavirus outbreak in mid-January, we ascertained that things would get worse before they were better. That is still the case, for public health and the markets.


The outbreak, officially known as SARS-CoV-2, and the disease it causes, officially known as COVID-19, were first detected in Wuhan City, China, and have since spread globally. The virus has now been detected in more than 40 countries (including the Diamond Princess cruise ship).

Concerns about the virus have recently sent global markets into a tailspin, and as an investment team that employs a global and dynamic approach, we've been asked for our thoughts regarding this phenomenon.

When we began navigating the potential effects of the virus on January 23, we instituted the first of a series of de-risking-oriented changes to a portion of our portfolios. We deemed this necessary given the uncertainty around the origination, nature, and eventual impact of the virus.

As we have moved through this week, our thinking from more than a month ago is now becoming conventional wisdom, and we continue to navigate in our portfolios commensurate with increased market risks and with an eye on widening opportunities.

The appropriate reference is the H1N1 flu virus of 1918-1919, more commonly known as the Spanish Flu.

Many epidemiologists and investors have tried to compare this virus to SARS, which originated in China's Guangdong province in 2002, or MERS, which originated in Saudi Arabia in 2012. Certainly, the type of virus and countries of origination are similar.

However, from our viewpoint, the more appropriate reference quickly became the H1N1 flu virus of 1918-1919, more commonly known as the Spanish Flu, due to their similar fatality rates and other factors (e.g., a higher fatality rate often points to a virus burning itself out before it can spread widely). This has guided us as we have tried to get a handle on the rate of infection, incubation period, etc.

In part because we also believed that the market would inappropriately maintain a focus on virus cases rather than on economic impact, we quickly shifted our focus from the virus itself to analyzing (1) how the markets will react to the illness as it spreads beyond its origination area, and (2) the impact on fundamental valuation-oriented factors for acutely affected countries (such as economic growth rates), especially given China's integral role in both the Asian regional and the overall global economy.

The former speaks to the near-term navigation focus we employ—“navigating the waves,” as we say. The latter speaks to the longer-term fundamental valuation orientation to which we adhere as our beacon in the storm—what we call “riding the tide.”


More specifically, in the currency portion of our strategies, we have navigated away from Asian currency exposure, moving formerly long exposures to be less long and short exposures to be more short. We have also increased exposures to safe havens like the Japanese yen.

In markets, we have reduced a net long aggregate equity exposure by about half. We have also shifted our fixed income exposure to shorten our duration after a steep drop in yields.

Our option replication program, which allows us to maintain a convex posture in our portfolios by mechanically selling equities as the market declines (and vice versa as the market appreciates) in prescribed amounts at prescribed strikes in a more cost-effective manner than through the outright purchasing of options, has also facilitated several sells of broad equity exposure in both Europe and the emerging markets.

We continue to focus on properly characterizing the environment in which a catalyst could spark a sharp move, rather than on potential catalysts themselves.


As we discuss the markets and our portfolio exposures with clients, at conferences, and in other situations, we are often asked what will cause a change in market direction, in sentiment, in volume, etc.—things often referred to as catalysts.

We have dismissed the notion many times in the past due to the difficulty, if not impossibility, of identifying a catalyst before the fact. However, it always helps when we can cite a specific example of why this is the case, and a good example is a Tunisian street vendor immolating himself as the catalyst for Arab Spring back in 2010.

Similarly, for this new virus emerging in early 2020, catalysts will always be almost impossible to predict accurately before the fact.

What we have and will continue to focus on is properly characterizing the environment in which a catalyst (whatever it may be) could spark a sharp move, rather than on identifying potential catalysts themselves.

Our prior communications about the global markets being in a state of susceptibility to a catalyst are now coming to fruition.

We are looking for liquidity events that will offer outsized rewards.

Looking for Order

As the situation unfolds, we are focused on several things, the first of which is how “orderly” the market decline is as it evolves.

As we have communicated in the past, traditional sources of liquidity in the marketplace have dried up since the global financial crisis due to regulation, risks, or other evolutions. This dearth of liquidity could materially exacerbate what would otherwise be a more muted market downturn.

As the markets continue to move down, we are looking for liquidity events that will offer outsized rewards to liquidity providers, which we have been positioned to be for some time now. Liquidity remains the most valuable aspect of an investor's portfolio, and we have focused on maintaining a highly liquid set of exposures for some time now. Given our recent navigation, we are currently in an even better position to take advantage of any market disorder should we see it. Thus far, we have not.

We are also looking for more traditional value/price gaps that are opening up as a result of the recent market turmoil. We want to be cognizant of trying to catch the proverbial falling knife, but as fundamental investors, we want to take advantage of opportunities to buy cheap markets or currencies that have now become much cheaper. We feel that we are well positioned to re-risk when and where we feel medium-term opportunities outweigh short-term risks.

Keeping an Eye on the 800-Pound Gorillas

Central bankers, the “800-pound gorillas” in the room and the prime influencers of risky asset prices, are also under our microscope.

We have already observed both jawboning and traditional (monetary) actions in response to the virus impact over the past couple weeks. This is particularly noticeable in Asia, where several central banks that have been historically reluctant to cut, such as Thailand's, have finally relented and done so.

We have also seen some more non-traditional fiscal stimulus strategies enacted. In Hong Kong, for example, every permanent resident aged 18 and older will be given an amount equal to roughly $1,250 as a part of the annual budget.

Will some of the larger Western banks react in a similar fashion to loosen monetary policy even further—thereby again providing a safety net for risky assets?

We have also recently increased our equity risk assumptions in our Outlook risk matrix. Outlook is one of two forward-looking views of risk we maintain, and it represents our assessment of the near-term (risk) environment in which we believe we are currently investing.

Monitoring the Situation

Lastly, we continue to monitor whether the future impact on economic growth prospects warrants a change to valuation inputs that might make an equity or bond market worth less (or more) as a result of the spread of the virus.

A change in the value of a market or currency is a longer-term phenomenon, to be sure, but there are times when a short-term development can have longer-lasting impacts on growth. We have built an analytical framework that allows us to monitor these on a real-time basis.

John Simmons, CFA, is a senior investment strategist on William Blair's Dynamic Allocation Strategies team.