Total time: 14:03

Bob Smith: Hello, everyone. I'm Bob Smith, Chief Investment Officer of Sage Advisory and I'm joined today by Komson Silapachai, Vice President and a member of our investment strategy team. As risk managers, we must be concerned about numerous issues that confront us every day. And the coronavirus looms as the most important near-term factor that continues to drive capital flows, risk valuations, and returns. So, what do we know about this emerging pathogen and emerging pandemic? To help us at Sage better understand the pathology and epidemiology of the coronavirus, we were fortunate to have received last week an in-depth presentation from Dr. Gail Perry-Smith, a professor of molecular biology out of the University of Texas here in Austin. According to Dr. Smith, the Wuhan virus is unique and scientifically novel in many ways, but one of its most important features is its ability to infect humans without immediate or near-term recognition. Thus far, the Chinese official reported mortality rate has been around 2%, but international scientists like Dr. Smith feel that it may be higher – perhaps closer to 10%. As of today, this viral outbreak has spread to every province in China, resulting in over 17,000 reported cases, with over 361 deaths, and the quarantine of millions of Chinese citizens. As the outbreak expands around the world, one of the concerns expressed by Dr. Smith is the ability to control the spread of the virus especially in underdeveloped countries such as the area surrounding China, parts of Southeast Asia, and the African continent countries. She believes the greatest challenge will be within the emerging markets and developing countries for they are the weakest links that may be the most vulnerable to succumbing to this outbreak.

2:02

Gail Perry-Smith: Well, the very young, the elderly, and people with conditions like for instance diabetes, emphysema, and history of smoking. These people would all be at risk.

2:20

Bob Smith: Clearly that's a contributing factor behind the mortality stats since the virus primarily attacks deep in the lungs and creates pneumonia-like symptoms, causing severe shortness of breath and cardiovascular stress. In China, the situation is exacerbated by one of the highest levels of smoking adult populations on the globe today. Clearly this outbreak has and will continue to have a direct economic impact on the Chinese economy, which represents about 18% of global GDP compared to about 4% when the SARS outbreak occurred nearly 20 years ago. One area of concern among many, is the fact that China is a big producer of pharmaceutical ingredients and finished products, which are largely exported to the U.S. and other countries. Dr. Smith said that Rosemary Gibson, a noted health specialist in the United States, noted in a book in 2018, that 85% of medicines in the U.S. national stockpile depend on some component from China; whether it's raw materials, the complete finished product, or intermediates. This could be a national threat for the U.S. as the outbreak deepens in China, which could affect their willingness and ability to export important pharmaceuticals abroad.

3:42

Gail Perry-Smith: Yes, people are suggesting we need government entity to monitor the medical supplies worldwide and medicines in particular.

3:51

Bob Smith: Currently, the economic impact from this outbreak has been more internal to China than external, but this may change depending upon the duration of the viral spread. China is a significant trading partner for the west across all major industries and agricultural markets. And there will be significant supply chain implication for U.S. manufacturers. It is economic concerns like this that bring people like Fed Vice Chairman Clarita to declare the coronavirus outbreak as a wild card for the U.S. economy and global markets, which could have an impact on Fed policy this year. So, it is important for us to understand how markets have withstood and performed in previous similar environments to manage our risk positions. Say Komson has there been a really impressive move to the downside for a lot of the established equity and fixed income markets, certainly the risk markets and have been moved to safety in Treasuries and places like gold. But how should people think about this event in terms of previous kind of market calamities of similar nature and what do you think they should be doing with their investment portfolios now?

5:11

Komson Silapachai: Well, the closest analogue Bob is SARS in 2003. However, you know, you can look at the bird flu episode in 2013, Ebola in 2014, the Middle Eastern Respiratory Syndrome in 2015, and kind of see, you know, use that as a starting point and that's what we did with our portfolio strategy. So, when you look at headlines and search data, after the peak of kind of hysteria, typically you see a market recovery in terms of risk assets. Now, one of the things about this virus that's really scary is the pace of growth of the novel coronavirus – it has well surpassed SARS, not only in magnitude, but in the speed and also I think the size of the U.S. economy. So when you compare the current episode to the SARS episode, the Chinese economy is about 20% of the global economy versus 5% in 2003. And so I think the strategy and how you should be thinking about your investment portfolio and how we're thinking about it, is thinking about sizing and you know, there are some positions where we have previous to the coronavirus, really high conviction on the equity side, previously we like the emerging world coming into the year. However, you know, I think the sizing of those positions have to be measured here. Also being diversified across the globe, across asset classes or within fixed income, I think having a full allocation, having a full duration in your portfolio to protect on the downside, and if we do own instruments and spread product, which is what we're doing right now.

6:56

Bob Smith: What do you think in terms of industries and companies? You know, when situations like this arise, people like to think about those that are going to be most likely affected by this in a negative sense. But also, there could be some beneficiaries out of these adversities as well. So, have you given any thought to that?

7:15

Komson Silapachai: Yes. And definitely, I think that the obvious ones, you know, that you've seen in past periods are the service sector in emerging Asia, luxury goods, travel sector, shipping. On the good side, I think one of the big risks really for the global economy is that emerging market Asia, particularly China, is a supply chain hub for high technology. For example, you know, producing mobile phones and the like, and as Bob mentioned before, pharmaceutical products. And so how much is this virus and the shutdown effectively of the Chinese economy for nearly a month going to affect the supply chains? And so those in unknown I think that's why a lot of these sectors have been hit. I think on a macro level it's really hard to say right now what will benefit, other than companies that are providing health care – so you're seeing pharmaceutical companies that have involvement in providing potentially a solution to the novel coronavirus really pop. So AbbVie. Today is February 3, Gilead seems to be rallying on some news that they're providing some potential solution here. You know, on a micro level, I think looking at this full-scale risk off, really a broad base selling of most sectors in emerging Asia as well as the U.S. equities on certain days. You know, finding value, what are the things that are insulated, that have a purely domestic exposure to the U.S. economy and not necessarily an international exposure? What are the sectors that don't have as much Asia sensitivity at this time? And then also as we get information, you know, hopefully we start to see the tide turn here versus the disease, are we going to get stimulus from the Chinese officials? And if that's the case, along with the potential solution, you could see a snapback in risk assets and so that's something we're watching for. We have some indicators that we're watching very closely.

9:25

Bob Smith: Well, you know, I can think of, airlines, anything related to transportation, to that part of the world, airports are other facilities that certainly in the bond market, we want to be looking at in terms of the various international centers that have shut down air traffic and what those revenue flows are all about. Clearly the energy sector is having a challenge right now and with the shutdown of all that international travel, obviously, you know, jet fuel requirements are going to go down significantly and that also is another impact on the energy sector. We know that from a shipping perspective, not only in terms of just raw trade, but also in terms of tourism, and the entertainment sectors, gaming stocks, things of that nature that have a very heavy influence from Asia, are all areas that obviously are under significant pressure. Areas that are obviously doing well, believe it or not folks, utilities has been the best performing sector in the market throughout all of this crisis compared to all other sectors in terms of the S&P 500, probably likely to stay that way for a period of time. Stay at home and stay safe is probably the underlying theme there because it's also expressed in U.S. Treasuries. So, we are seeing some widening as Komson said in spreads, we are seeing a de-risking on the part of investors in general. So, what have we done at Sage, and maybe Komson you could share some of the things that we've done in recent weeks and kind of the reasons why. Is it all because of the coronavirus or is the coronavirus something on top of what we’ve already perceived?

11:08

Komson Silapachai: Right. Thanks, Bob. Yeah, I think coming into the year, we were already running a low level of risk across strategies. So, after such a, you know, now it's novel coronavirus downing headlines, we sometimes forget how unprecedented last year was in terms of positive market moves. And so, we thought that after last year, we were still constructive on the global economy. However, spreads and valuations level really weren't compensating investors for the risks that were in these markets. And so, we've been running a low level risk coming into 2020, obviously did not see the magnitude of the virus that we have today, but we benefited from that and being somewhat defensive in our fixed income strategies, and so we're focusing on areas where we think have better risk reward characteristics such as securitized markets, mortgage backed securities, asset backed securities, commercial mortgage backed securities. Within our interest rate posture, we're maintaining a good amount of interest rate sensitivity, full duration versus our benchmarks. And within our strategies that have multi assets or have equity exposure, we've trimmed our equity beta areas, like small cap U.S., and things that we think will not do as well and kind of a choppy period where we have these fits and starts and kind of uncertainty and overhang/. And so, that's really in a nutshell Bob kind of how we're positioned. Obviously, this is a developing situation and so everyday kind of, I think brings new pieces of information. But as of now, I think this is really kind of the best course of action going really for the next month to three months.

12:57

Bob Smith: For Dr. Smith, Komson, and myself Bob Smith, I want to thank you for listening.

13:04

Disclosures: Sage Advisory Services is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This podcast is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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