In recent weeks, news headlines have been dominated by the coronavirus outbreak, which has infected nearly 80,000 people and resulted in more than 2,600 deaths, according to the World Health Organization.
In China, the epicenter of the outbreak, factories have closed, travel has screeched to a halt and supply chains have been disrupted. As the virus spreads (South Korea, Iran and Italy are also reporting cases), other countries have taken similar precautionary measures, further intensifying the economic impact.
No one knows for sure how severe the fallout will ultimately be – that will take several more weeks to determine – but a few aches and pains are in store over the short term. Further out, however, global markets and economies will likely prove resilient. There are two reasons for this:
Country after country put in place monetary and fiscal stimulus policies well before the coronavirus began to spook the markets. If the virus is contained, companies are expected to restock inventories in the coming months.
The Federal Reserve cut rates three times in 2019, while emerging markets also implemented their own forms of monetary easing. Not to be outdone, a host of Asian economies, including China and Thailand, put forth significant fiscal stimuli as well.
Also last year, as banks pulled back from the repo market, which had sparked concerns that liquidity could dry up, the Fed began to purchase short-term bonds. That action drives more demand for those instruments, which not only reduces borrowing costs, but also tends to stimulate economic activity and support higher equity valuations.
In the three months leading up to the outbreak, the global outlook was trending up. And while economies will undoubtedly experience some contraction in the short term (especially in China, where growth is expected to slow materially), it looks like policymakers have added ample stimuli to ensure that any hangover from the coronavirus will be minimal.
Last summer, many feared the economy would begin to encounter more headwinds, thanks to the emergence of a yield curve inversion, which typically foreshadows recession, and concerns that after nearly 12 years of rising equities, markets would start to pull back. So, instead of restocking inventories, many firms used capital in other ways, including stock buybacks, dividends and mergers and acquisitions.
But in retrospect, it's not clear that last summer's yield curve inversion was based on souring economic fundamentals. Rather, it's entirely possible that the wave of refinancing that occurred in the wake of Fed rate cuts and bond purchases was the issue.
When borrowers refinance, insurance and mortgage service companies must replace longer-term bonds in their portfolios, a practice that lowers yields. This time around, it likely happened at such a rate as to produce a technical yield curve inversion but not one, in retrospect, that should have caused as much anxiety as it did.
Furthermore, it's important to remember that expansion cycles do not die of old age. That usually happens because of central bank mistakes, such as raising interest rates too high, too soon.
That's probably not going to happen this time around. Before tightening its policy, the Fed has stated that it wants to see year-over-year inflation run at 2% or more for a sustained period, something that's not likely to occur for a while. Firms, therefore, that only a few short months ago were wary to make long-term commitments might feel less comfortable operating with light inventories.
In this environment, the primary beneficiaries will be international equity markets and the most cyclically sensitive U.S. stocks. U.S. small-cap stocks in the Russell 2000 Index (.RUT) may also benefit, but to a lesser degree. All three categories could experience returns surpassing the S&P 500 (.SPX) over the next six to nine months.
The most cyclical international market that saw the largest outflows over the past two years is Japan, followed by emerging markets and then the Eurozone. Three exchange-traded funds to consider in these areas include (EWJ), the iShares MSCI Japan ETF; (VWO), the Vanguard FTSE Emerging Markets ETF; and (VGK), Vanguard FTSE Europe ETF.
A promising small-cap ETF to gain exposure to the Russell 2000 Index is IWM, while a good way to access U.S. cyclical stocks is through materials, particularly the Materials Select Sector SPDRs ETF (XLB).
Another cyclical sector to consider is energy, specifically exploration and production companies. High-potential energy firms include ConocoPhillips (COP), Devon Energy (DVN), and Diamondback Energy (FANG).
The domestic exploration and production industry has recently undergone a transformation from rapid production growth to free-cash flow generation, which supports crude oil prices and makes for more predictable earnings models. The group is under-owned and inexpensive and likely to stay that way.
If the SARS outbreak is any guide, fears about the coronavirus should begin to fade around mid-March. And while this most recent global outbreak has caused far more deaths than SARS – which also originated in China – the global health community has learned since 2003 about fighting contagious diseases.
That progress, along with prolonged monetary easing and fiscal stimulus, as well as inventory trends over the next few months, ought to provide investors with confidence that 2020 will be another good year for their portfolios.
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