Market risk: Financial markets withstanding coronavirus epidemic

Market risk from coronavirus? Don't panic.

The coronavirus is stirring up fear. Panic is the wrong response for investors, though, since the financial markets have a healthy immune system. This is also evident when we look back on market developments during past epidemics. The market risk can be minimized through smart portfolio diversification.

Epidemics have only a limited impact on the financial markets

"Even the strongest man will sometimes check under his bed." Erich Kästners's timeless remark seems to hit the nail on the head for the ongoing concerns of many investors. At the individual level, fear-driven behavior is not just rational – it can even be crucial to survival. But as a collective phenomenon, fear follows an entirely different kind of logic. The greatest danger it poses is its contagiousness. After all, fear begets fear.

The progressive spread of the coronavirus is also raising fears. Many investors are now wondering if "the big bear market" is just around the corner. This type of worry is nothing new. In the past, though, epidemics have come and gone with the global stock market performance staying relatively immune.

financial markets quickly recover from global epidemics

Financial markets quickly recover from global epidemics

Source: Charles Schwab, FactSet data
Last data point: January 21, 2020
Historical performance and financial market scenarios are not reliable indicators of future results. 

Unanticipated market risks are often overblown

It is still a good idea remember three things given the current spread of the new virus from China:

1. The coronavirus struck the global financial markets like a classic black swan – a potentially large risk that had not even been on the radar. Experience tells us that such major risks are often underestimated at the start. Then they escalate until they are actually overblown. Once fear gains the upper hand over market participants, however, recovery is usually not far behind. And as soon as the markets see reasons to give the all-clear, they suddenly reverse.

2. Good diversification or opportune hedges are crucial in such phases. Chinese equities have depreciated since the virus broke out. A balanced discretionary mandate in Swiss francs has been in slightly positive territory since the start of the year, though. This is a reminder that the best protection against risks is smart diversification based on investments, currencies, themes, sectors, and countries.

3. The SARS virus outbreak in 2003 could provide lessons for the financial markets. Like today, China and Hong Kong were particularly affected by the disease back then. The Hang Seng Index started to correct in January 2003, when the epidemic broke out. The equity market bounced back, though, as soon as the number of new infections stabilized in early April, and went on to achieve new highs. Something similar could happen this year as well.


The financial markets achieved new highs in Asia after the SARS shock

Source: World Health Organization (WHO), Citi Research
Last data point: July 2003
Historical performance and financial market scenarios are not reliable indicators of future results.

Reducing market risk through smart diversification

The current situation has three consequences for investors: First, the financial markets pay larger risk premiums in the long run. People who invest with a cool head, a long-term horizon, and smart diversification will earn these risk premiums over the medium term – and thus protect and increase their assets.

Secondly, what matters in the markets is not just the current developments, but also what is expected. Once this epidemic has subsided, the Asian markets will recover as well and perhaps even overshoot their prior levels. In any event, a well-diversified mandate will benefit from this in various ways.

And third, there is a lot of potential for the euro to move back up once the epidemic and the fears have passed their peak.

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