A health story becomes an economic one

For a couple of reasons, the next few weeks are going to give investors an interesting ride. The first is what I expect to be a rise in short-term volatility as the coronavirus crisis shifts from being a human health story to an economic one. The second is the evidence that last year’s remarkable stock market rally is persuading previously cautious investors that it is safe to go back into the water.

During the ‘white coat and face mask’ phase of the coronavirus story, when attention concentrated on infection and mortality rates, the stock market has been happy to look through short-term uncertainty to focus on the pattern of previous outbreaks. The assumption, probably correct, has been that in due course the virus will be contained, and things will get back to normal.

We are now moving into a second, ‘spread-sheet and profit warning’ phase when the spotlight shifts to the economic impact of the outbreak. This is when the authorities focus on policy measures to get businesses back on their feet and companies begin managing their investors’ expectations. Last week this process moved up a gear with the likes of Apple, BHP and Procter & Gamble starting to come clean about the effect China’s February shutdown would have on their first quarter earnings.

Goldman Sachs is just the most high-profile of market watchers to warn in recent days that investors may have underestimated the impact, in the short-term, of the virus. It says comparisons with the 2003 SARS outbreak may be too optimistic because of the growing importance of China to the world economy today. The Chinese economy is six times larger than it was 17 years ago and China’s tourists alone might account for 0.5pc of global GDP.

What’s clear from the corporate updates that are now turning from a trickle to a flood is the extent of China’s shutdown. The economy has not really restarted after the New Year holiday, in large part due to the wholly sensible quarantine precautions the authorities have imposed. This was well illustrated by the recent story of the eight-bed dormitories at an Apple supplier being enjoyed, if that’s the right word, by single isolated workers sitting out their two-week separation from colleagues.

The knock-on impact of factories not returning to anything like full capacity on the commodity markets and the shipping industry is profound. The role of the New Year holiday in disguising the scale of the problem is only just being understood as ships start to arrive in the waters off China’s ports to pick up cargoes that aren’t ready to be loaded.

Goldman Sachs makes another point, which strikes me as being even more interesting, about the different ways in which the markets for shares and commodities work. And it is this difference which explains why we should expect more market gyrations in the weeks ahead than we’ve experienced thus far.

The equity market tends to look through short-term disruptions, assuming that any activity that is missed this quarter will be replaced in subsequent periods. The further assumption is that monetary and fiscal stimulus can boost output down the track. In the round, the crisis might even be a net positive over the course of a year or so. This is why shares are at or close to all-time highs.

But commodity markets don’t work like this. Their job is to balance the supply of physical goods with the demand for them. Equities are forward-looking instruments. Commodity markets are much more concerned with the here and now. The key question is how relaxed stock markets will remain about taking the long view when the short-term picture for copper and iron ore starts to get choppier.

As news on the depth and duration of the slowdown ebbs and flows, I expect investors to look more closely at what really drove markets higher in 2019. The lion’s share of market gains last year was due to an upward shift in valuations. Essentially, investors were prepared to pay more for every unit of earnings as they became more convinced that lower interest rates would underpin the delivery of those profits in 2020.

At the end of 2018, when recession was on every investor’s radar, valuations in Europe were lower than in three of every four prior years. Today they have only been higher 15pc of the time. That’s a complete transformation in sentiment and one that is reflected in those much more optimistic investment flows since the turn of the year.

Now for the tricky question. Are those bullish investors right or wrong? The slightly unhelpful answer is that they might be both right and wrong over differing timescales. In the short-term, they may feel they’ve made the wrong choice if volatility picks up and prices correct. If a potential pandemic can’t trigger a meaningful re-pricing of risk then what can, you might ask? The odds of a correction are certainly higher than they were.

But in the absence of the usual recession triggers - rising interest rates and over-borrowed households, for example - profits and dividends should continue to grow in the longer term, even after the longest economic expansion in a century and a half.

There is an important difference between volatility and risk. The first is an unavoidable part of investing. The second is nothing to do with the short-term ups and downs of the market but rather measures the probability of permanent loss of capital. A tried and trusted way of benefiting from the former while avoiding the latter is to drip feed your money into the market over time. Investors who are sensibly taking advantage of ISA and SIPP allowances in the next few weeks should remember that they don’t have to put their money to work straight away.