Covid-19: The pin that popped the bubble

Last year, global equity markets delivered the best calendar year return of the decade. Many markets were at or near all-time highs. Fast-forward a quarter and 2020 is already the most volatile period in modern investing history. We know this because the VIX tells us so. In three short months, global markets have broken record after record. None of them pleasant.

The S&P 500 recorded its fastest transition from bull to bear market. The benchmark US stock index succumbed 20% in just 20 days. During the global financial crisis, it took 274 days to enter bear territory. The median length for all bearish drawdowns since 1915 is a sluggish 156 days. The index also posted three consecutive daily moves exceeding 9% for the first time since October 1929.

The media has inundated us with Covid-19 reporting. We all know that the pandemic caused the market rout. But we didn’t know it was coming. Donald Rumsfeld would call it an unknown unknown.

Let’s momentarily cast our minds back to the pre-pandemic economic environment. The world was still an unpredictable place as we turned the decade. Yet much of the geopolitical uncertainty of 2019 had begun to abate.

The signing of phase one of the US/China trade deal in January was encouraging. Full accord would of course need more and difficult debate. But the world’s economic powerhouses seemed to have passed peak trade uncertainty. Removing this economic headwind would add meaningfully to US, Chinese and world GDP growth.

In Europe, the United Kingdom had finally withdrawn from the European Union. Formal withdrawal after 1,317 days of relentless and fractious debate marks only the beginning of a transition period. London and Brussels must now hammer out the details of their future relationship. But business could finally begin to plan and invest.

In the US, the Federal Reserve had cut interest rates successively three times. The loose monetary conditions and persistent real wage growth augured well for an improved 2020. Markets as we have written were on lofty valuations. Barring a material unknown unknown, the chances of a US recession and market rout were low.

Then in early January, the media reported on a severe flu emerging from Wuhan, in China’s Hubei province. Commentators drew quick parallels with the 2003 SARS epidemic. To limit contagion, the Chinese authorities resolved to quarantine first Wuhan, then Hubei and lastly much of China’s 1.4 billion population. With hindsight, this action was not quick enough.

Today, the infection approaches one million confirmed cases in 192 countries and territories. Nearly 50,000 people have perished. Governments have quarantined one fifth of the world’s population. All these statistics will inevitably worsen.

It is self-evident that investment markets are forward looking. But investors’ reaction to the global contagion was mostly coincidental. Perhaps because of a grave misunderstanding that regional efforts would restrict the virus to Asia (like SARS in 2003). Or because the human mind struggles to understand and value large unknowns.

Whatever the cause, the lag in the market’s response gave investors worried about valuation risk time to hedge their portfolios. Some of us were already partially hedged. We took the opportunity to add more protection. But not all fund managers were worried. The evidence is in the very wide dispersion of mutual fund returns last month.

The market rout began in earnest in March as the virus began to spread globally. Industrial commodities and oil were casualties of the expected economic slowdown. The Russia-Saudi Arabian oil price war added to the panic. The market declines have been painful for investors. But we are grateful that our decision to protect investor capital limited our fund’s draw down to less than half the market’s decline.