A view on financial markets, a new threat

Friday, 6th March 2020 11:09 - by David Harbage

After worrying about trade tariffs and Brexit last year, investors now face a new fear – of an entirely different sort – in the form of COVID-19, better known as the Coronavirus. The first case was reported in Wuhan, China on 31 December 2019 and the disease has subsequently spread around the world. Beyond the human tragedy, the cost to the global economy – as workers are quarantined, manufacturing output stalls and travel is disrupted – will be significant and is, as yet, open ended.

Ahead of our usual update at the end of the first quarter, this blog seeks to address today’s most commonly asked question surrounding stock market investment: ”Should I remain invested in equity (company stock or shares) investment when the prognosis for the disease and its potential impact on the world is so uncertain?”

The stock market endeavours to quantify the risks, as well as the merits, of individual asset classes and investors should be mindful of their own appetite for stability (reliability of income and preservation of capital worth) as well as their objectives before making financial decisions and selections. Incidentally, it might be helpful to write the latter down, putting numbers to the current amount of income on offer from various assets alongside anticipated living, plus exceptional capital, expense. The writer would encourage the reader to revisit his blog of 14 August 2019, ”Where else to invest, beyond company shares?” asking this question against a backdrop of negligible returns paid on Cash accounts and less than 1% per annum yields offered by British Government stock.

Subject to being comforted by the appropriateness of equity investment – successful companies offer the prospect of real (inflation beating) growth in income (via higher dividends), in turn leading to the potential for the asset’s capital value to appreciate – which s generally considered to demand a time horizon of at least five years (but preferably ten plus), let’s consider the specific risk of Coronavirus.     

The prime threat is that the disease becomes more aggressive, more difficult to treat with existing remedies and the pace of contagion accelerates – resulting in more workers being quarantined and finding consumers reluctant to travel or socialise. According to the population affected, so an economy’s ability to function will be jeopardised; this can be considered at both a global and local level. The longer that a factory or economy is ‘closed down’ the more likely it is that permanent damage will be caused as an adverse effect ripples out from the site.

One can look back at previous pandemics (the Russian flu of 1889/90 caused 1m deaths worldwide, Spanish flu of 1918/19 resulted in an estimated 25-50m deaths, Asian flu of 1957 resulted in 2m deaths, Hong Kong flu of 1968/69 between 1-4m deaths, less fatal were Avian or bird flu occurred in 1997, SARS in 2002, Ebola in 2014). Studying these global viral or bacterial diseases is interesting as a means of trying to assess the potential magnitude of the problems which Coronavirus could cause, but the history is of limited use as medical science has advanced, populations continue their concentration in cities and the global economy has become so much more inter-dependant. Incidentally, it took two years to find a FDA approved vaccine for Ebola.

In terms of the impact within the UK of previous pandemics, it is estimated that the Russian flu cost 132,000 lives, Spanish flu 228,000 lives, Asian flu 33,000 lives and Hong Kong flu 80,000. By contrast, our ‘ordinary’ perennial flu has been attributed as the cause of approximately 15-20,000 deaths in Britain over the past decade; although the quality or reliability of such data is probably low. It should be recognised that there is no cure for the common cold or the flu (although there are vaccines and medicines to ameliorate the virus) and terms such as flu or pneumonia (an infection causing inflammation of the lungs) have often been ascribed as the cause of death when other disease may have been contributory.

While we do not yet know enough about this new disease, the elderly or those with respiratory problems seem to be at most risk from Coronavirus, but the fear of contracting the disease has prompted dramatic action on the part of governments and corporations. State-driven self- isolation in affected places may have been helpful in reducing the spread of the disease, but we now appear to have reached the point of likely widespread contagion. The speed with which it infects more of the population, the extent to which individuals are quarantined or decide to self-isolate, (that public meeting places are avoided) is an unknown, but will determine the economic impact.

Stock markets respond to material changes and anticipate future prospects (somewhat belatedly in this particular instance) as, since 1 January 2020, UK and global government bonds and investment grade corporate bonds have appreciated by circa 3% - as investors have sought stability, away from the turbulence in the pricing of economically sensitive, risk assets. These gilts and quality bonds have also anticipated central banks’ easing – lowering interest rates in order to stimulate economic activity and restore confidence in jittery financial markets. Earlier this week, the United States’ central bank (the Federal Reserve) made an emergency rate cut – something only previously seen this millennium following the September 11^th terrorist event in 2001 and in the financial crisis of 2008 - of 0.5%, to a range of 1%-1.25%.

By contrast, equity markets have fallen in response to the prospect of Coronavirus delivering a negative hit on corporate profitability – notably in anticipation of supply shortages and weakening demand. The FTSE100 index began 2020 at 7,561 and rose to 7,690 on 17 January before plummeting to 6,500 on 1 March and registering 6,680 at the time of writing. Individual company share prices have been marked down – as one might expect, based on which individual industry segments or particular companies are perceived as being most at risk.

Amongst FTSE100 index constituents AstraZeneca and GlaxoSmithKline, which manufacture respiratory medicines, have fallen 2.5% and 7% respectively, cruise ship line Carnival and International Airlines Group, the owner of British Airways, have fallen by 41% and 33% respectively while non-economically sensitive (safe havens and beneficiaries of equity only funds’ switching into) utilities like National Grid and Severn Trent have bucked the general trend, by rising 9% and 4% respectively in the year to date.

Other sectors which typically suffer in an economic slowdown or outright recession include banks (as interest rates fall and bad debts rise) and oil companies (as demand falls); Lloyds Banking Group shares have fallen 26% and BP shares have retreated 15% in 2020. For an entirely different reason, investment trusts – often championed in this blog - have typically weakened; as sellers outweigh buyers, so the difference between the trusts’ share prices and the underlying worth of their assets (net asset value, expressed as NAV per share) have usually widened.   

So, back to the original question ”Should I remain invested in equity (company stock or shares) investment when the prognosis for the disease and its potential impact on the world is so uncertain?” The questioner should revisit the standard basic principles and features of such investment – is it suitable for them – in terms of:

(a) time-scale, as mentioned earlier, anticipating the monies being undisturbed for a period of 5-10 years or longer

(b) acceptance of volatility (price movement), with its lack of guarantee in terms of return (of capital, as measured by share price, in particular, but also income pay-out)   

(c) diversification, ensure that long term savings are spread between differing asset types (not just equity) and also that the equity investment is sufficiently diverse (by business activity, geography and individual company)

(c) current and future income is key to valuing an asset, with the prospect of today’s income rising in future years (if dividends are increased). Such an asset, along with property that produces rent, offers the potential – but not guarantee – of its income keeping pace with inflation and, in turn, the prospect of preservation of the real (as measured in purchasing power) worth of its capital.

Currently the FTSE100 index yields 5.1%, which compares favourably with the British Government 10 year gilt’s 0.35% and today’s best no-notice Cash account of 1.2%. Immediate prognosis is for the Bank of England to reduce UK Bank rate this year, in sympathy with the 31 cuts elsewhere in the world which have already been seen to date in 2020, to stimulate economic activity. Such a move helps to underpin the worth of real assets – for example, cheaper mortgages increases demand for homes prompting appreciation in house prices and lower borrowing costs encourage businesses to invest and individuals to consume.

A recession (defined as two subsequent quarter periods when output falls) could, of course put dividend payments in jeopardy – with certain companies at greater risk (either because existing earnings barely cover the current distribution or those whose business is especially adversely impacted by the Coronavirus) than others. Many stock exchange listed firms operate a ‘progressive dividend policy’ (seeking to at least maintain, if not hike their payments) to shareholders, and owning the wider UK equity market through an index tracking vehicle provides the investor with greater confidence – that the income arises from potentially hundreds of different companies’ dividends - than being in a few individual businesses.   

Having successfully ‘hurdled’ the above barriers to entertain equity investment, the investor who actively monitors and manages their investments may be tempted to sell part or all of their equity investment – in the belief that they will be able to repurchase at a lower price. However, history suggests, and industry professionals (independent financial advisors and fund managers) agree, that this is a high risk strategy, because the financial markets can move very quickly – often in response to knowledge that has yet to become public – and most traders do not beat the market.

The twitchy investor has to take a view on Coronavirus, if one thinks it could be pandemic and extend beyond the elderly to afflict say 5% of the world’s population with a resultant 1% rate of fatality (equates to 3.350,000 and 670,000 people in the UK, for instance), then there is almost certainly further downside potential in equity markets from today’s valuation (especially on Wall Street).

A more optimistic or benign perspective might suggest that a vaccine will be found by the end of the year for this variant of flu (albeit a more dangerous version of our perennial domestic disease), that warmer temperatures will act as a headwind to the disease and that, aided by central banks’ efforts to stimulate demand, China along with the rest of the world’s economy will recover to the point of real GDP growth resuming in 2021.

However, until evidence of the latter appears, and with the media likely to maintain a focus on the human and economic damage wrought by Coronavirus, investor sentiment is likely to remain weak and momentum in equity markets negative. It is important for investors in equity to remember that markets will be ready to bounce back or, for that matter, fall heavily upon any change in the news flow.

History shows that the combination of irrational emotive forces and computer-driven trading activity will take share prices lower or higher, (as relative valuations can be ignored at times of extreme positivity), than a fair or sensible price. That should not matter much to the long term prudent investor – whose eye is probably on the dividend outlook – but to expect markets to behave in this way is to be mentally prepared.

With the benefit of being able to look back, we can see that many of the threats to equity investment have proven to be temporal (prompting the saying that “markets climb a wall of worry”) but, of course, one can never be sure of how a particular new risk could pan out. In our digital world, bad news travels fast, and the fear of Coronavirus could have as a great an adverse impact on the global or our local economy as the disease itself.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.