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The case for and against the Coronavirus creating the next GFC

March 4, 2020

The case for and against the Coronavirus creating the next GFC

The sudden drop last week took investors by surprise. Many believed the coronavirus had already peaked but by the end of last week, the S&P/ASX 200 fell 9.77% while S&P500 fell 11.49%.

At the time of writing, coronavirus, or Covid-19, has spread across China and Asia, and started to fan out across many more regions of the world including Europe and Australia. Fatalities worldwide now totals more than 3,000.

The 11-year bull market has been one of the calmest we’ve seen with only a few major corrections where US stock prices approached a full 20% correction only twice. Maybe this is why coronavirus wasn’t considered a serious risk. Wall Street just had one of their worst weeks since the GFC, and most countries are now starting to step up efforts by banning travel, and postponing major events and conferences. 

Control is tightening around the borders as the disease continues to spread, creating a double effect on the market – firstly, by the virus itself, secondly by the reaction of the market. 

The real issue is the economic slowdown caused by the world’s reaction to the virus. Imports and exports from China have slowed dramatically, NZ stats saying the virus may have cost as much as $300 million in lost exports to China in the last month. Businesses have curbed usual activities (Apple just announced they’re restricting their employees to travel to Italy and Korea while major airlines such as American Airlines and Air France are suspending flights).

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As productivity slows down, analysts are wondering whether the coronavirus could wreak havoc at the same scale as the 2008 financial crisis.

Scott Minerd of financial services firm Guggenheim Partners said the coronavirus outbreak “is possibly the worst thing I’ve ever seen in my career”. For reference, his career has spanned three decades and included two other major crashes – the 1987 crash and the Lehman Brothers bankruptcy. 

Jennifer McKeown, head of economic services at the consultancy Capital Economics, has a more balanced outlook. While she believes there’s reason to worry, she points out that there is still time to contain the virus and avoid a financial crisis. 

However, she also said: “One thing becoming clear is we just can’t predict the spread of this and how bad it can be. But it’s not difficult to get to something similar to the 2008 crisis with a pandemic situation. Of course, we hope it won’t get that bad.”

Ray Dalio, in his most recent coronavirus related article on LinkedIn, pointed out that there are three different components to the virus – the disease itself, the economic impact of reactions to the virus and the market action. 

“They all will be affected by highly emotional reactions. Individually and together they lend themselves to a giant whipsaw with big mispricings, with the off chance that it will trigger the downturn that I have been worried would happen with both the big wealth/political gap and the end of the big debt cycle,” Dalio says. He does not believe the coronavirus will have a long-term impact on the economy and says it should lead to V- or U- shaped financials for most companies where they drop in revenue until the virus is over, to then rebound. 

“Reactions to the virus (e.g., “social distancing”) will probably cause a big short-term economic decline followed by a rebound, which probably will not leave a big sustained economic impact.”

With that said, Dalio emphasises the point that he doesn’t know what will happen and that the opposite could be possible too, although he doesn’t think it’s likely. 

Recessions are caused by economic slowdown. The exact definition of an economic recession is a significant negative economic growth over two consecutive quarters. It is often caused by a rise in unemployment or an increase in inflation. As unemployment rises productivity goes down resulting in higher prices and inflation. When costs increase, people tend to save money rather than spend it, resulting in a reduction of economic output.

While many are waking up to the risk of coronavirus, others are maintaining a positive long-term outlook rather than worrying too much about what the virus might mean or not mean. 

Iconic investor Warren Buffett CEO & Chairman of Berkshire Hathaway, is one of them, asserting that buying stock is buying a business, and that it’s very hard to predict what will happen short-term. The long term outlook is what’s important. 

“My reaction is that I like to buy stocks, so I don’t wish ill on anybody else. But if they want to sell them to me cheaper, I prefer it,” Buffett said in an interview with CNBC’s Becky Quick. 

He says he doesn’t believe in investing based on today’s headlines. He buys stock like he would buy a house, with a 10, 20 and 30-year outlook, not necessarily implying we won’t go into the next GFC. Just that he prefers to invest long-term in any case.  

Warren Buffett is considered one of the most successful investors of our time. His methods may seem counter-intuitive, but have resulted in Berkshire Hathaway outperforming the markets considerably and consistently since 1965.

An increase in volatility continues. On Wednesday 4 March the XJO finished down 110.30 points at 6,325.40, and the US market closed its Tuesday session down 86.86 points at 3,003.37. While it is still impossible to predict what is going to happen next, it is still worth keeping an eye on history. Whether or not the coronavirus will create the next GFC and the market will go up, down or sideways from here, it has already changed the market and proven to be a short term obstacle to investors. And we believe it is always sound to have hedges in your portfolios in any case.

Over the last six months we have been looking at investments that provide a hedge, or benefit from market pullbacks and increasing volatility. We currently have a very interesting one that is created by investment banks for hedge funds and used by sophisticated investors.

While most portfolios are set up for a predictable, stable market, we are living in unusual economic times. Previous similar investments have been popular with people looking to set themselves up with a unique opportunity to benefit from the uncertainty. 

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