Shortly after Coronavirus began spreading in Italy, we published our post How We’re Thinking About Coronavirus. In that post, we outlined our belief that the economic impact of Coronavirus was extremely difficult to forecast, and that information must be meaningful and actionable in order for investors to use the information in ways that increase their expected return.
In this post, we’ll lay out what actions we are taking based on our current forecasts and offer a preview of how we expect to act as more information becomes available.
First of all, let’s be clear; the Coronavirus has already had a meaningful negative impact on economic activity and this negative impact will continue. The question at hand is how negative the impact will become, how long it will persist, and finally how the economy will behave after Coronavirus recedes.
Here’s an economic scenario analysis put together by Bloomberg.
Here’s another way to think about a Widespread Contagion impact on the US economy from Goldman Sachs. Note that this chart is showing the impact on GDP. So the -3% in Q2 would be about -1% GDP if you assume 2% growth ex-Coronavirus.
And finally here is ISI Group, one of the very best economic teams on the Street whose work we’ve followed closely for two decades, who this morning said they now expect a quick and sharp recession followed by a rebound.
At Ensemble Capital, we’re in the business of evaluating individual companies, not making economic forecasts. However, while we think that typical economic cycles are nearly impossible for anyone to forecast correctly, what is happening right now is not so much a typical longer cycle economic slowdown but an abrupt “halt” to economic activity that is taking place right now. While it is beyond the abilities of economists to know if this event will tip the US and the rest of the globe into a recession, it is very clear today that many segments of the economy are experiencing, or are about to experience, sharp drops in demand.
So, in practical terms what that means is that we have adopted a set of assumptions across our portfolio that assumes a very meaningful negative impact to demand that lasts for about six months. Of course, beyond the overall economy wide impact, we’ve also considered company specific impacts since Coronavirus will very clearly hurt some companies much more than the average company, while indeed it will have little impact or even improve the economic outcomes of other companies.
As a broad narrative, this outlook assumes a very sharp, short term economic contraction followed by a rebound. This economic shock risks pushing weaker economies into recession but may not do the same for stronger economies. However, we’re well aware that even though the US economy is relatively healthy with strong new jobs numbers reported for February, if the Coronavirus shock is severe enough it could ripple through the economy and cause a recession that persists beyond the end of this outbreak.
Why do we expect the direct impact to only last six months? Because every viral outbreak has behaved that way. The big question is how bad it gets, more than how long it lasts. Even in the worst-case example of the Spanish Flu, the outbreak ran its course over just a few months (although it did come back the following year, much like Swine Flu continues to circulate in the US every year despite fading in economic relevance).
The Spanish Flu was 100 years ago, and the world is a different place. But the underlying biology of viruses have not changed. In this report written by the Federal Reserve in 2007 about the economic impact of the Spanish Flu, you can read the relatively optimistic sounding assessment. It is also useful to note that the US stock market was up 11% in 1918 and up 30% in 1919. The Flu itself didn’t help the economy or the market obviously, but it is important to recognize that there are a nearly infinite number of inputs into what drives the market and the economy (which is why they are impossible to predict in the short term). And of course, we know the Roaring 20s followed the Spanish Flu with robust economic and financial market gains for a decade.
The fact is that a recession will indeed come, the only questions is when and why. A year ago, many people thought that a recession would come due to the Chinese economy slowing down and the trade war. But the US economy only slowed modestly and has been reaccelerating. The Coronavirus outbreak could be the event that triggers the next recession. But if it doesn’t there will still be a recession at some point later. This is an underlying operating assumption for every investment we make. While we can’t time recessions, we know they will occur from time to time and we only make investments in companies we believe can successfully navigate them and come out healthy on the other side.
Since we seek to be invested in companies that we believe are undervalued, a negative reassessment of the value of a company does not necessarily mean that we will sell or trim that position. It means instead that at any given market value for the stock, we would want to own less today that we would have wanted to own under our prior forecasts.
As a general statement on our total portfolio, we believe that the negative economic impact of Coronavirus on the value of our holdings is most likely going to end up being less than the amount that their stock prices have already declined. This means that today, we believe our portfolio offers a higher expected return over the next five years or more than it did prior to Coronavirus breaking out in Italy, and the related selloff in the US stock market. Not because Coronavirus doesn’t matter, but because the impact of this event on the intrinsic value of the companies we own is likely less than the nearly 20% decline that has occurred over the past few weeks in the broader stock market.
We’ve also stress tested our portfolio holdings to confirm our belief that even under a far more negative outcome, each company can continue to operate and will not face a cash flow crunch that could prevent them from making it through the crisis.
While we cannot know today whether the crisis will recede more quickly than we expect or whether it will spiral into a Severe Global Outbreak that causes a global recession, we can continue to monitor the situation and be prepared for the moment when the probabilities begin to shift more clearly towards a different scenario than the one we currently expect.
The problem is that today, the information that is known about the Coronavirus economic impact is still consistent with a range of future outcomes. In the simple drawing below, we show three paths that could play out over the next year or more. The blue arrow points to today.
As we move forward in time, we will approach a point where the crisis begins to follow a path that is no longer consistent with a better or worse outcome than our base case. However, it is still extremely difficult to know what that information might look like. It may well even be hard to recognize the information once it arrives.
For instance, Italy has announced they are locking down their entire country, much as China did in Wuhan, in an effort to contain the outbreak. How does this new information impact our scenario analysis? On the one hand, we know that China’s response appears to have worked relatively well. While they didn’t stop the outbreak, it has not run rampant across all of China, active cases have gone into decline, stores and factories are reopening, etc. On the other hand, we know that the lock down in China has had huge negative ramifications on their economy. And we know that, in general, it is not the health impacts of viral outbreaks that cause most of the economic impact, but the actions taken to stop the outbreaks that causes most of the damage.
What this means is that it may be a mistake for investors to focus on the spread of the virus and they should instead focus on the actions taken to stop it. Not just the official government actions, but just as importantly the behavioral changes being made by businesses and consumers. While it would certainly have meaningful social impacts, the economic impact of people being sick and even dying is minimal at the macro level. Conversely, people not going to work and not spending as usual would have profound economic implications, if only for a time.
This is an important point, but it can sound callous. The stock market is not a measure of how much good or bad there is in the world, it is a measure of the long-term value of corporate cash flows. The steps that Italy and China took to try to limit the health impact of the virus may cause a worse economic impact than if they had not shut the country down. That does not mean they made a mistake. It may be well worth accepting economic losses to limit the health impact of Coronavirus. But it is important for investors to not confuse the two issues when making investment decisions.
That’s why we’re closely monitoring charts like this one that shows how the progression of the outbreak in Italy is following a very similar path to how things played out in China, but also keeping in mind that active cases and death counts are not the same as the impact on corporate earnings or the degree of economic drag.
At some point over the next month or two, the scale of the negative economic impact of Coronavirus will become clearer. While on the one hand it would give us and our clients some mental comfort to simply assume the worst case outcome and act accordingly, the fact is that the best investment opportunities come not from always assuming the worst, but by having better calibrated expectations than other investors. The very best investment opportunities come about precisely because the crowd assumes the worst, leaving stocks priced so that they perform well even if the actual outcome is bad (but not as bad as the worst-case outcome other investors assumed).
But while investors get paid to not assume the worst if they indeed are right, this does not apply to much of everyday life. Making sure your family is prepared for an emergency is just good common sense. Of course, you should have an emergency kit, of course you should be prepared for possible disruptions to supply chains, of course your company should have a plan in place to ensure business continuity and the safety of all employees. The costs of “over reacting” to risks is often low in everyday life. But anyone who knows someone who assumed that financial markets would never recover from the financial crisis and decided to liquidate their portfolio can tell you how overreacting to risks is one of the surest ways to destroy your financial situation.
At Ensemble Capital we’re committed to being transparent in how we are managing our clients’ assets. While we can’t tell you what will happen in the future, we can tell you how we are thinking, what we are doing, and how you can expect us to behave under various future scenarios.
While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.
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