March Private Client Letter - Navigating a Crisis

We at Clearwater Capital Partners have often written about the importance of “facts over feelings” when it comes to navigating periods of market volatility and uncertainty. The current breakout of the novel coronavirus has produced a significant spike in feelings (specifically “fear”). Now is the time to keep emotions in check as we attempt to ascertain the “facts” connected to this difficult situation. We believe one’s reaction to higher volatility will be far more determinative to long-term progress than the volatility itself.

Coronavirus – An Overview According to researchers at Johns Hopkins University, over the past eight weeks the coronavirus (also known as COVID-19) that originated in the Chinese city of Wuhan has infected tens of thousands of people across Asia. It has claimed the lives of over 3,000 people and has spread to dozens of other countries.

The coronavirus outbreak began in December in Wuhan, the capital of Hubei Province and the largest city in central China with a population of around 11 million. Experts believe the likely source of the outbreak somehow is connected to the Huanan Seafood Wholesale Market in downtown Wuhan, where it is thought the virus was initially transmitted from animals to humans.

By January 23, there were over 800 cases of the coronavirus confirmed globally, including cases in at least 20 regions in China and nine countries or territories. The city of Wuhan was placed under quarantine by Chinese authorities with all flights, trains, and long-haul buses into and out of the city suspended. By the end of January, authorities had enforced transportation restrictions in an additional 15 cities in Hubei Province. Together, over 51 million people have been affected by these quarantines and restrictions.

Still, Wuhan is a major transit hub for the region, with direct connections to dozens of other cities in China. The coronavirus outbreak coincided with the lunar new year which is the most popular time of the year for domestic travel. By the time the quarantines and restrictions had been implemented there, an estimated 5 million people who were potentially exposed to the virus had already left Wuhan, greatly complicating efforts to contain the virus.

The COVID-19 virus is part of a family of viruses that includes SARS (severe acute respiratory syndrome) and the Middle East respiratory syndrome (MERS), both of which have led to deadly outbreaks in the recent past. This latest virus can cause respiratory infections, the effects of which range in severity from common cold-like symptoms to fatal respiratory illness.

The virus can cause pneumonia. As this is viral pneumonia, antibiotics are of no use and the antiviral drugs that are effective against the flu will not work. Those who have fallen ill are reported to suffer coughs, fever and breathing difficulties. In severe cases there can be organ failure. Recovery depends on the strength of the immune system and many of those who have died were already in poor health.

The latest data from China stem from an analysis of nearly 45,000 confirmed cases, and on the whole suggest that the people most likely to develop severe forms of COVID-19 are those with pre-existing illnesses and the elderly.

While overall, 2.3 percent of known cases proved fatal—which many experts say is likely an overestimate of the mortality rate, given that many mild cases might go undiagnosed—patients 80 years or older were most at risk, with 14.8 percent of them dying.

While less than 1 percent of people who were otherwise healthy died from the disease, the fatality rate for people with cardiovascular disease was 10.5 percent. That figure was 7.3 percent for diabetes patients and around 6 percent for those with chronic respiratory disease, hypertension, or cancer.

Deaths related to the coronavirus have occurred in every age group except in children under the age of nine, and, generally speaking, “we see relatively few cases among children,” World Health Organization Director General Tedros Adhanom Ghebreyesus said last week.

Scientists don’t know what exactly happens in older age groups. However, based on research on other respiratory viruses, experts theorize that whether a coronavirus infection takes a turn for the worse depends on a person’s immune response.

Virologists and epidemiologists around the world continue to work to determine how contagious and potentially fatal the coronavirus might be. Compared to SARS and MERS, the coronavirus appears to be spreading unusually fast. The MERS outbreak took about two and a half years to infect 1,000 people and SARS took roughly four months, however the novel coronavirus reached the 1,000 infected threshold in just 48 days.

So far, the data supports the belief that the coronavirus is significantly less fatal than either SARS or MERS with an estimated death rate of around 2.3 percent of infected people as mentioned above. By comparison, the fatality rate for SARS was around 10 percent, and the rate for MERS was around 35 percent.

That said, the novel coronavirus outbreak has been difficult to monitor. Experts believe that the virus is most contagious during its incubation period, which can last up to two weeks. Humans can transmit the disease before symptoms appear, rendering detection and containment much more difficult. Current understanding about how the virus that causes coronavirus disease spreads is largely based on what is known about similar coronaviruses.

The potential for misinformation and unwarranted panic is currently very high relative to the coronavirus. Many in the public fear the coronavirus outbreak could scale into a full-blown pandemic, while public health experts urge patience until more details about the virus are known.

"It is important to know how to distinguish between the advice and information coming from public health authorities and scientists, versus the misinformation that is instigating unnecessary fear," says Lauren Gardner, an epidemiologist at Johns Hopkins University who is tracking the spread of the outbreak.

Adding to the difficulties surrounding the coronavirus are delays and inconsistencies of official statistics released by various governments and public health officials.

As of March 2nd, the outbreak has affected an estimated 89,000 people globally. In mainland China there have been 3,048 deaths among over 79,000 cases, mostly in the central province of Hubei. More than 45,000 people affected in China have already recovered.

Public health officials around the globe have mobilized to cope with the rapid spread of the virus. Facing a shortage of treatment facilities in Wuhan, government officials commissioned in late January the emergency construction of two new hospitals. In the United States, the Centers for Disease Control and Prevention (CDC) has established quarantine stations and implemented enhanced passenger screening programs at several major international airports.

In response to the ongoing public health emergency related to the spread of the coronavirus, researchers from Center for Systems Science and Engineering (CSSE) at Johns Hopkins University have developed an interactive web-based dashboard to visualize and track reported cases in real-time. The dashboard, first shared publicly on January 22, illustrates the location and number of confirmed COVID-19 cases, deaths and recoveries for all affected countries

This dashboard was developed to provide researchers, public health authorities and the general public with a user-friendly tool to track the outbreak as it unfolds. A screenshot of the dashboard appears above and the live web-based version can be accessed by clicking here: Johns Hopkins COVID-19 Dashboard

As the number of reported coronavirus cases continues to grow, repercussions have been felt across the world. On January 30, the World Health Organization declared the novel coronavirus outbreak a Public Health Emergency of International Concern, and the U.S. State Department issued a Level 4 travel advisory. This Level 4 travel advisory strongly discourages Americans from traveling to China.

The outbreak has had a rapid and measurable impact on the global economy. Travel restrictions and flight suspensions have dramatically reduced tourism, and many international companies, including Starbucks and McDonald's, have temporarily closed locations to mitigate risks of further transmission.

Impact on Markets It may take months, if not years, for the full impact of the Wuhan coronavirus outbreak to be known. However, investors appear to have taken a “sell now, ask questions later” approach. Just seven trading days ago, U.S. equities were trading at record levels. Last week the U.S. stock market suffered a historic pullback as the coronavirus spread outside of China, frightening investors and traders out of equities.

The Dow Jones Industrial Average and S&P 500 each dropped 12% and 11% for the week, respectively, marking their worst weekly performance since the financial crisis in 2008. The 30-stock Dow posted its biggest one-day points loss ever on Thursday. It also tumbled deep into correction territory, down more than 10% from a record high, along with the S&P 500 and Nasdaq Composite.

The downdraft marks the fastest decline for stocks from a record high into a correction ever, outside of a one-day crash.

Wall Street’s dramatic sell-off were triggered by worries over the coronavirus’ impact on the global economy and corporate profits.

While the number of new cases in China kept rising, the number of new infections spiked in South Korea and Italy. Numerous companies are now issuing warnings about their earnings.

Last week Microsoft indicated its current-quarter revenue guidance for its personal computing division — which accounts for 36% of the company’s overall sales — would not be met as the coronavirus slows down its supply chain. PayPal warned that the coronavirus will negatively impact its revenue forecast. Mastercard said the virus could dent its 2020 revenue.

All 30 Dow members ended last week down more than 10% from their respective 52-week highs. Tech giant Apple even dipped into a bear market, briefly trading down more than 20% from its intraday record set on January.

Traders and investors sought protection from the stock market’s decline by loading up on U.S. Treasury bonds. The benchmark 10-year Treasury yield broke below 1.10% for the first time ever on Monday, March 2. Likewise, Wall Street’s so-called fear gauge — the CBOE Volatility Index (VIX) — surged to its highest intraday levels since February 2018.

Based on an analysis of the 50-day moving average spread, the S&P 500 is now “extremely” oversold and traders are looking for a relief rally to develop. Since World War II, the S&P 500 has had 26 market corrections (excluding the current one). During those corrective periods, the S&P 500 has declined by an average of 13.7% and has taken about four months to recover.

Impact on Economic Growth & Earnings Expectations

Given growing concerns of a prolonged slowdown to global economic activity due to the coronavirus, equity analysts have lowered earnings estimates during the first two months of the quarter for companies in the S&P 500. According to FactSet, the Q1 bottom-up EPS estimate has dropped by 3.3% during this period.

It is important to note that while this 3.3% decline is above the five-year average and the 10-year average, it is not an unusually high number. It does not rank as one of the 10 largest declines in the bottom-up EPS estimate (over the first two months of the quarter) in the past 10 years. It is also much smaller than the declines of - 23.6% and -27.8% recorded during the first two months of Q4 2008 and Q1 2009.

It is possible that analysts may be waiting for more guidance from companies before revising estimates even lower for first quarter. So far, only 68 S&P 500 companies have issued earnings guidance below expectations. Even this number is below the five-year average of 75 (FactSet).

This said, a number of S&P 500 companies have indicated they were unable to quantify an impact from the coronavirus. Accordingly, there may still be an increase in the number of companies issuing negative guidance later in the first quarter as these companies gain clarity on the impact of the coronavirus on their businesses. This potential increase would also likely lead to more downward revisions to EPS estimates.

Where to From Here

It is impossible to know at this stage of the crisis how many people will become infected by the coronavirus. It is likewise impossible to judge the extent to which this crisis will reduce global economic activity and corporate profits.

What we do know that health care professionals and government agencies around the globe have mobilized to minimize the spread of this disease with quarantine protocols and travel restrictions. The Centers for Disease Control and Prevention (CDC) is now delivering new testing criteria and resources. We can take some comfort in the growing body of data that indicates the coronavirus in far less deadly when compared to previous endemics. Many adults with the virus may barely feel sick, or fully recover without having to be hospitalized.

As part of the FDA’s ongoing and aggressive commitment to address the coronavirus outbreak, the agency issued a new policy for diagnostics testing during the public health emergency. The new policy is for certain laboratories that develop and begin to use validated COVID-19 diagnostics before the FDA has completed review of their Emergency Use Authorization (EUA) requests.

There have also been several news stories suggesting that researchers are moving quickly to develop an effective vaccine against COVID-19. One such story involves research funded by Israel’s Ministry of Science and Technology in cooperation with Israel’s Ministry of Agriculture, the MIGAL Galilee Research Institute.

It is hoped that this research could be on the verge of a scientific breakthrough that may lead to the rapid creation of a vaccine against coronavirus in the coming weeks. Specifically, MIGAL has revealed that the poultry coronavirus has high genetic similarity to the human COVID-19, a fact that increases the likelihood of achieving an effective human vaccine in a very short time.

Conclusion

From a historical perspective, an intelligent argument can be made that crises such as these are eventually resolved, and both the economy and markets snap back. This said, it is simply too early to sound the “all-clear”. The degree to which people change behavior out of fear of the virus is almost certainly going to have a larger impact on the near-term economy than the virus itself.

The U.S. economy went into this crisis in very good shape and investment strategies were positioned accordingly. All we can ask of ourselves at this point in time is to remain calm and monitor developments closely. Our outlook for 2020 will most certainly be adjusted as more information becomes available, however a panicked response (given the many unknows) appears ill-advised.

Over much of the past year, your team at Clearwater Capital has been adjusting portfolio strategies to reduce risk, improve quality, and lessen overall equity exposure. This does not suggest that our accounts will escape the negative impact of the current crisis; it does however indicate that we continue to exercise discipline when it comes to investment strategies.

Finally, please know that we understand how stressful periods like this can be. We welcome your calls and inquiries should you wish to discuss the current situation in greater detail. As discouraging as things may currently appear, please be reminded that this too will pass. We are confident the U.S. economy will eventually recover from this crisis and recapture any lost growth. In other words, we believe the economic effects related to the coronavirus will be transitory in nature.

We will continue to monitor all developments closely. Thank for your continued confidence.

John E. Chapman, March 2020