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Webster defines Event Risk as the possibility that an unforeseen event will negatively affect a company, industry, or security. However, the spread of the COVID-19 virus has massively expanded the scale of that definition to now include the US and Global economies. It has become the catalyst for what is now the correction we wrote about in our January letter to clients. We didn’t see COVID-19 coming but rather expected the catalyst to be economy or market-related. Over the prior four months ending January, we had raised cash through tax selling and rebalancing. Whether this correction morphs into a flash bear market of short duration depends not only on how COVID-19 affects human behavior and the economy, but also the effects of the response to it by governments and the healthcare industry. At this time, we see the US economy being slowed by this event, but not to the point of Recession. If this holds true, investors could view this pullback as an opportunity.

Investors Should Always Expect the Unexpected

To some, that means being always ready to make dramatic shifts in portfolio exposure based on what they see in the headlines. Sadly, that often proves detrimental to investment returns since most headlines aren’t significantly impactful to the economy beyond the near-term. Remember Greece, Ebola, Brexit? Those are just a few items that roiled the markets for a time but didn’t halt the expansion of the economy. The structural collapse of the financial system in ’08 was real news, not just noise, since it impacted confidence and liquidity for an extended period and brought about the Great Recession. All of the above sent many investors to the sidelines. The latter prompted some to never return for years until stock prices were much higher. That hurts long-term performance.

For us, being prepared for the unexpected means having sufficient liquidity available to meet financial needs for 1-2 years and avoid any dramatic changes in asset allocation for any other reason than a big life change: health, divorce, death, etc. That liquidity can take any form of current income, cash, bonds, CDs, and money market funds. In other words, something other than equities. It gives an investor the freedom to meet expenses, make subtle, tactical changes in their portfolio based on intermediate-term expectations. That way, they can bridge their portfolio through whatever event is affecting the markets regardless of the impact. Doing that even prepares investors for what is happening today with COVID-19.

From our Investment Outlook posted on September 12, 2019: “Looking ahead into the first half of next year, and absent any unanticipated event, a recession doesn’t appear on the menu for the US economy.” Later, in our December issue where we addressed the likelihood of a market correction in Q1 of this year: “Given that the data points to a positive outlook for the economy in 2020, any retracement should be transitory.” In quarterly statement letters to clients that followed both postings we advised they have their liquidity needs be met for the next 12-18 months. So were they prepared for the uncertainty brought about by COVID-19 event? Those who heeded that advice are prepared and in a position to pursue opportunities in its aftermath.

The Rise of Uncertainty

Uncertainty is a constant condition for investors, only the level of intensity varies. Through mid-February, the matrix of economic data that we monitor pointed to improvement in the manufacturing sector, continued momentum in consumption, and robust employment/wage growth. That positive trend will likely succumb to the rise of uncertainty as the virus spreads and the duration of its transmission lengthens. The psychological effect on human behavior will, to some degree, translate to certain sectors of the economy such as travel by air or cruise ships. Restaurants, retail, and merchandising are also likely to be affected. The initial uncertainty we have relates to the COVID-19 event itself. Driven by “an abundance of caution”, government and local authorities can dictate widespread closure of schools, businesses, and public spaces. This response can, in hindsight, be an overreaction and have a longer-term negative effect on the broader economy.

COVID-19 could become viewed as a harsher version of the flu that targets a specific risk group rather than a highly lethal pandemic as some fear.  If so, the economy would have been disproportionately affected and the markets might, as they almost always do, overreact to the downside. Unfortunately, we can only wait and see if that becomes the case. That uncertainty is currently driving the extreme volatility we’re seeing in the stock and bond markets. While healthcare providers combat the virus, the first responders to the economic consequences have been the world’s central bankers, led by the Fed. In our view, lowering interest rates is more symbolic than imparting any tangible benefit at this juncture. However, if the transmission period stretches unabated for several weeks more, we can expect to see a fiscal stimulus response from the government, benefiting those most affected by the event.

Update on Risks to Expansion

The Fed: We’ve crossed this one off our list. Benign

Trade War: Truce with Phase One agreement. Waiting for Phase Two. Moderate

Europe and the Global Economy: Brexit accomplished. Trade Agreement forthcoming. Risk level remains Moderate

The Election: Expectation for dramatic shift in fiscal policy remains Moderate.

 COVID-19: Trade, travel, healthcare, corporate earnings are all negatively impacted. The event encompasses all three theaters of the Global Economy. Transportation and supply chains are disrupted. China slowing, recession risk for Europe increasing. The US is likely to slow as well, but recession is unlikely. Will the response by authorities be an overreaction and exacerbate the effect of the virus on the economy? Significant

The Outlook

We recommend investors be patient as the current news cycle runs its course. We’re on the lookout for news of the transmission rate of the virus reaching a plateau and declining along with the number of cases and deaths. Approximately 55% of those affected by the virus have fully recovered while roughly 3% have died. Over the course of the next several months, news that those ratios have remained constant or are decreasing will point to when and where the markets stabilize and the slowing of the economy ends. Those that are prepared will find that to be an opportunity to strategically increase their equity exposure in under-valued sectors.

Conway • Jarvis LLC