Clients of Brown Brothers Harriman’s Private Banking practice know that we are patient stewards of our clients’ wealth. We allocate capital into financial markets based on deep fundamental analysis and an appreciation of the opportunity afforded by the difference between the value of an asset and its market price. Accordingly, we are careful to draw a distinction between those macro developments that threaten to impair sentiment, and therefore price, and those developments that threaten to impair fundamentals, and therefore value. The spread of the new coronavirus and the associated COVID-19 disease threatens to impair both.
We have no further insight into the disease itself beyond what the Center for Disease Control or the World Health Organization offer on a daily basis. Some context or framework, though, may help to understand the daily litany of reporting. The effort to control this outbreak is following the same paths as previous health emergencies: understanding the efficiency of transmission (how the virus passes from one person to another), determining how long an infected person remains contagious and working to control the size of the susceptible population. The first of these variables is rather clear: like other coronaviruses (including the common flu), the method of transmission is airborne droplets. The second variable – duration of infectious period – also seems clear at about 14 days, although the fact that victims may be contagious without being symptomatic complicates the ability to identify carriers. The final variable depends on a combination of vaccination and quarantine: reducing the susceptibility or size of the population at risk.
These three variables combine into a concept that epidemiologists call R0, or “R naught,” which measures how many new cases of a disease an existing patient is expected to generate. The objective is to get R0 below 1, through some combination of vaccination and quarantine.
Therein lies the risk to the economy, corporate earnings and financial markets. Until a vaccine is available, the only way to reduce the size of the susceptible population is by quarantining likely victims and encouraging people and businesses to mitigate the risk of infection further by limiting interaction. China responded early in the outbreak by quarantining the Hubei province and its capital, Wuhan, closing schools, cancelling flights and so forth. Supply chains are so short and tight that the ripple effects are already affecting businesses around the world, in ways that will only become clear over time.
The direct risk to the domestic economy is the degree to which American consumers alter their own behavior. If consumers stop going out to dinner, taking vacations, traveling for business and so forth, the impact on the U.S. economy will be meaningful. Personal consumption is not only 68% of gross domestic product (GDP), but consumption has also been the driving engine of the economy throughout the course of this record-long expansion.
As the nearby graph demonstrates, this cycle has been punctuated by short downturns in economic activity from time to time. The economy contracted in the first and third quarters of 2011, again in the first quarter of 2014 and was largely flat in the fourth quarter of 2015. The disruption to supply chains and consumption resulting from COVID-19 may very well lead to a contraction in the first quarter of 2020 as well. This is bad news but is mitigated somewhat by recognizing that contraction has happened before in this economic cycle. Again, we have no unique insight into how this plays out, but if the disruption proves to be temporary, the economy can recover without lasting impairment.
We believe that the deeper impact will appear in corporate earnings, although we may not see the true extent of that until companies begin to report first quarter earnings. The risk is more obvious for companies that rely directly on manufacturing facilities in affected countries. We will likely learn, however, that the second- and third-order effects are damaging as well.
Consensus expectations do not yet reflect this. As of February 27, analysts are still expecting corporate earnings growth of a modest 2% in the first quarter of 2020 (the first gray bar in the nearby graph). Expectations will come down as the true extent of supply chain disruption becomes clearer.
It is important to note that price volatility is a feature of financial markets, not a bug. The current correction marks the 23rd time in this bull market that U.S. equities have dropped by 5% or more from a peak. Each and every correction has its own cause – in August of 2019, fear that an inverted yield curve was signaling near-term economic stress prompted a sell-off of 6%. The markets recovered to close the year with a healthy gain. The average correction in this cycle has been close to 10%, with a duration of 2 months. Market corrections are the norm, not the exception.
Furthermore, markets tend to rebound swiftly following a sharp sell-off and a spike in volatility. There have been 12 instances in the past 30 years in which the Chicago Board of Exchange Volatility Index (VIX) spiked above 35, indicating substantial market stress. As the nearby table shows, market disruption historically lingers in the short term, but the further out from the volatility spike, the more likely that the market has rebounded robustly. One year later after the VIX spike the market was positive 10 out of 12 times, with an average 14.7%.
The two exceptions to this rule were the wake of the dot-com bubble (2001) and the onset of the global financial crisis (2008), where markets were lower a year later. In both cases, a downturn in economic fundamentals led to a bear market, which is precisely why we will keep a keen eye on any economic impairment arising from COVID-19.
We have not adjusted asset allocation in response to previous corrections, and we are not adjusting portfolios at present. Asset allocation for each investor is largely a function of liability allocation. Money is a means to an end, and what an investor needs a portfolio to do – provide income, hedge against inflation, preserve liquidity and so forth – drives the asset allocation. Asset allocation should be strategic, and not reactive to a market correction.
We are in constant contact with our portfolio managers as this event unfolds. Our managers construct portfolios of high-quality businesses that they are able to acquire at a discount to intrinsic value.1 We believe that these companies will continue to thrive over long and volatile periods, and price declines provide us with the opportunity to add to positions, or establish new ones, at attractive valuations.
A strict focus on valuation discipline implies that our managers have been holding cash as equity markets have risen. Notably, cash has increased over the past few months. At present, in a taxable balanced growth portfolio (65% equity and 35% bonds), our equity managers hold an aggregate 5.3% in cash, leading to an effective underweight in equity.2
Our equity portfolios are underweight in the sectors that have been hardest hit on a year-to-date basis, including energy, materials and financials. We have almost no exposure to energy, and we are significantly underweight financials (especially banks). Fixed income is an important source of stability in client portfolios, and BBH’s fixed income managers have held up well in the current downturn.
Our portfolio managers are keeping a wary and cautious eye on these developments. As markets decline and compelling investment opportunities emerge, our managers will be disciplined in investing cash, as well as upgrading portfolios to higher quality companies that trade at discounts to intrinsic value. While opportunities continue to get more attractive, we are not rushing to invest cash balances down to zero. Our managers remain opportunistic, but cautious.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved PB-03363-2020-02-27
1Intrinsic value represents what we believe to be the value of a security based on our analysis of both tangible and intangible factors.
2Holdings are subject to change.