14 May 2020
The unprecedented threat posed by the novel coronavirus to public health, and the extreme measures by governments to contain its spread, have had severe knock-on effects for the global economy. Just how long and deep this economic disruption ends up being, however, is difficult to determine. This “fear of the unknown” is being reflected in the world’s financial markets and, until we see clear evidence of the pandemic’s containment, volatility will continue to shadow markets.
The coronavirus pandemic is certainly a “black swan” financial market event – coming from nowhere to present a new and significant risk. However, what is not new is the extreme psychological response from investors in the face of this risk. This herd mentality – of individuals acting collectively in response to a perceived threat – is an understandable, and remarkably consistent, human behaviour. As such, the kind of fear-driven investor response we are seeing currently is well known, and our investment playbook in this environment is tried and tested. As in previous market crises, a resolute focus on fundamentals, and maintaining a long-term perspective, are crucial to successfully negotiating this difficult period.
If there was any doubt, the seriousness of the threat posed by the coronavirus pandemic has been made clear in recent weeks with heavy losses recorded on US and global equity markets. However, it has been the pace of the declines that has particularly shocked investors. From an all-time high on 21 February 2020, the S&P 500 Index suffered the quickest descent into a bear market (i.e. a fall from peak of more than 20%) on record – just 16 days – as fears about the global spread of the coronavirus took hold.
As in previous market crises, a resolute focus on fundamentals, and maintaining a long-term perspective, are crucial to successfully negotiating this difficult period.
(Fig. 1) From Peak to Bear Market During Periods of Market Crisis
The tumult has been even more pronounced in the US smaller companies’ segment, with the Russell 2000 Index finishing Q1 2020 -30.6% lower than it began. While certain areas fared worse than others (energy, for example, suffered badly as oil prices plunged), all sectors finished notably lower.
Given the evaporation of confidence, it was little surprise that smaller companies suffered more than their larger market constituents. Smaller companies tend to lead the market into a downturn, and this was again the case as worried investors dumped riskier assets indiscriminately and in volumes. At its lowest point during the quarter, on 18 March, the small cap Russell 2000 Index was -42% down from recent highs. Yet, for all the talk about the unprecedented nature of the coronavirus risk, and as significant as the decline clearly is, it is not unusual in the context of previous bear market environments.
During the two most recent major bear markets, namely the dotcom bubble collapse of 2000-02, and the global financial crisis of 2007-09, US small caps lost -44.1% and -58.9%, respectively. This knowledge will be of little comfort to small cap investors today, but it is important to highlight that we have been in similar situations before. And on each of these previous occasions it also felt as if the crisis might leave the world forever altered, and that markets might never fully recover the losses.
Figure 2: US Smaller Company Performance in Severe Bear Markets
Past performance is not a reliable indicator of future performance.
Source: FTSE Russell (see Additional Disclosures). Data analysis by T. Rowe Price. As of 31 March 2020.
As worrying as the coronavirus pandemic is, the swift and significant fiscal and monetary action from the US government and the central bank, is encouraging. With similar policy action taken by other countries around the world, this could ultimately help to limit the depth and duration of a likely economic recession.
However, more needs to be done towards successfully resolving the crisis, before we can move onto the recovery phase. Once governments begin to ease lockdown restrictions, businesses will start to assess the extent of the damage done. How quickly companies can deal with the effects of the shutdown and return to normal business practice, will determine the length of the road to recovery.
In a best-case scenario, one in which the pandemic is soon brought under control, it is possible that the US economy bounces back relatively quickly. And just as they typically lead the market on the way down, smaller companies also tend to lead on the way up.
Our experience through previous market crises tells us that this is not a time for changing course. No one can anticipate the full impact of the coronavirus or the associated near-term market movements. It is equally impossible to time the bottom of the market or the beginning of a recovery. The high level of uncertainty means that, more than ever, this is a time for cool heads, for focusing on strong fundamentals, and for maintaining a long-term investment perspective.
With this mindset, we see the current volatility as an opportunity to improve portfolios and potentially emerge from the crisis in a stronger position. While some repricing of assets is necessary in light of the coronavirus pandemic, we will almost certainly see an overreaction (if we have not already) as herd mentality prevails and indiscriminate selling spreads. This can be seen time and again throughout history as investors react out of fear to the immediate noise and volatility and so make irrational, short-term decisions – mistakes that will later seem all too obvious with the benefit of hindsight.
A significant question yet to be answered is what impact the pandemic, and the extreme measures to try and contain it, will have on corporate earnings? First quarter results will give a good indication, but the second quarter reporting period will provide the first full accounting of how corporate America has been affected by the crisis. Near-term earnings, along with GDP numbers, will not be pretty, but the question is just how bad will they be?
Few companies, big or small, will be unscathed. The longer economic disruption continues however, the more exposed smaller companies will be, with some potentially finding it difficult to survive. Smaller companies are generally more tightly run than their larger counterparts, with less cash held on balance sheets, and fewer resources to draw upon when needed.
Over the coming quarters, almost all companies will see their profits scythed and this will have a significant impact on their ability to keep operations running, as well as their ability to borrow money. Highly levered businesses, or those that have suffered a sharp decline in revenues, will find it more difficult to borrow in the new environment. Meanwhile, little or no debt, and ample cash will be critical determinants of survival for many.
The coronavirus pandemic, while worrying, is ultimately a finite scenario, and we believe the global economy looks fully capable of rebounding as and when the crisis abates. Meanwhile, pockets of opportunity exist for disciplined, selective investors with a long‐term investment horizon. This is perhaps most apparent in the US smaller companies’ sector, as the uncertainty caused by the coronavirus has seen investors shed riskier assets indiscriminately.