January proved to be a roller coaster ride for global equity markets. The month started with an unexpected escalation of tensions in the Middle East between the US and Iran, but after both sides made clear their intentions to de-escalate the situation in the near term, increasing risk appetite drove many equity indices to new all time-highs on an almost-daily basis. This dynamic reversed around mid-month as markets began to digest the full scope of the public health challenge posed by the outbreak of coronavirus in Wuhan. As the rate of daily infections continued to climb and authorities took increasingly pro-active measures to limit the spread of the virus, risk assets underperformed as investors fled to safe havens. Many global markets, particularly Asian, finished January well in the red as did the barometer of cyclical risk known as the Australian Dollar.
Much has already been written about the outbreak of the 2019 novel coronavirus. I do not think we can add much to the debate by speculating about the potential timelines for a resolution or the path such an outcome is likely to follow. Instead, I offer the following brief observations:
- Practically, the first-order impact will be to Chinese growth, since many businesses will remain closed beyond the traditional Lunar New Year holiday period to limit the spread of the virus. Disney, for example, said they are budgeting for the Shanghai and Hong Kong Disneyland’s to be closed for two months.
- The broader shutdown and quarantine of 50 million people will have an immediate negative impact on local Chinese consumption, but as it drags on, will also start to place pressure on global supply chains, many of which still use China as a critical part of the manufacturing process.
- Given that Chinese demand represents much of the delta in growth rates for many companies and economies (including Australia), a prolonged slowdown could have a material negative impact on global growth in 2020.
The key question for markets is whether authorities manage to contain the spread of the virus over the near term, or whether it becomes something much more disruptive with a longer time horizon to resolve. For now, I continue to be cautious about deploying capital, given the inherently difficult-to-forecast nature of the outcomes. An external shock of this nature could prove to depress the modest momentum seen in the global manufacturing cycle, which is why I still prefer to be tilted towards businesses that can grow under their own steam as opposed to purely relying on a cyclical recovery or fiscal spending to drive revenue growth. At present, my base case for 2020 remains a slow rebound in global growth as industrial activity improves, particularly outside of the US. While the coronavirus outbreak may delay the rebound, I don’t think it changes the trajectory at this juncture. Should I be wrong in this view, I expect additional rounds of monetary and fiscal support from central banks and governments around the world. That thinking is perhaps why developed equity markets have so far had a somewhat muted response to coronavirus.
Any worsening news-flow will likely see equity market volatility over the near term. From experience, we know that such volatility can provide opportunities to gain or increase exposure to high quality names at more attractive valuations. For now, I do not intend to dramatically decrease our exposure to multinationals with China-facing exposure (such as Nike, Walt Disney or LVMH), as we think these businesses are still long-term winners. While the impact caused by a slowdown in China will have an outsized impact on near-term revenue and cash flow growth rates in those stocks, we don’t want to overreact to what is hopefully a short-lived disruption. I do stand ready to deploy capital, but will be patient in doing so at an appropriate margin of safety on a per-stock basis.
Speaking about stocks, the US quarterly earnings season has been playing out against the highly uncertain macro-economic backdrop outlined above. In general, companies are exceeding expectations as I wrote about last week and providing relatively positive outlook statements for 2020, though an early recurring theme has been management teams cautioning investors about the potential negative impact of coronavirus to their operations. Nevertheless, several leading US stocks have delivered solid results despite the fraught operating environment. Microsoft handily beat expectations and guided to operating margin expansion ahead of market consensus. Given the breadth of its offering and the incumbency status the company enjoys in the enterprise IT space, we believe Microsoft is the best positioned play in the hybrid cloud environment and will remain so for the foreseeable future.
In conclusion, despite coronavirus volatility, I remain cautiously optimistic for 2020. In the meantime, I think we can all expect a few more weeks of volatility as short-term sentiment ebbs and flows on updates out of China and updates from China facing businesses. However, I will stress, there is generally investment opportunity in bouts of above average volatility driven by what is most likely a short-term event. I will wait for my moments to deploy cash.
My investment philosophy is underpinned by the belief that companies that earn above average returns on invested capital will deliver superior shareholder returns in the long term. I remain focused on the stock fundamentals and look to own high-quality business that can compound their cash flows over the years ahead. If Mr Market gives me a chance to buy more of those “compounders” with a clear margin of safety, I will act.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.