The recent outbreak of the Wuhan Coronavirus is a topic that is at the forefront of all investors’ minds, particularly since information out of China is spotty and the numbers that are supplied by the Chinese government need to be met with high scrutiny. Many would wonder how the world’s second largest economy seemingly grinding to a halt would not cause a market sell off. The market reaction thus far has been relatively muted for several reasons:

The first reason is the derivative effects of the virus that the market is currently pricing in. The market is confident that China will be able to relatively contain the virus before it becomes a full-on Global Pandemic. From what we know now, the mortality rate from Coronavirus is relatively low. Figure 1, located below, plots the Coronavirus mortality statistics against similar outbreaks. As this is being written, only two deaths have been confirmed due to the virus outside of China. In the last few days several Chinese factories have announced that they are resuming operation and workers are returning to facilities. A minor detail that may soften the impact to U.S. companies’ inventories is that the virus outbreak has taken place over the Chinese New Year which is a period where factory output is predicted to be depressed. What the market is then pricing in is that once economic production resumes, economies will undergo a sharp increase in activity to make up for lost production due to the virus. Think of this as a “V-Shape” bounce on a graph.

Another derivative effect that the market is looking forward at is Central Bank stimulus. Just in the last few days the Peoples Bank of China injected 900 billion yuan (about 129 billion U.S. dollars) into the Chinese financial system. U.S. investors are predicting that the impact from the virus, and subsequent impact to GDP, will cause the Federal Reserve to continue to be accommodative via their own repurchase operations and possibly another rate cut. Many companies that have reported numbers in the last month have also given wide forward-guidance due to uncertainty from their supply chain status. This should dampen the shock that investors will get if subsequent numbers are materially impacted from their production or inventory drawdown...

Tariffs have been at the forefront of economic headlines over the past year. If the market headlines do not include “United States Threatens to Impose New Tariffs” then it most likely includes “Markets rise on the hope of a Trade Deal”. This has been the never ending cycle for the last year. On May 10^th, 2019 the Trump Administration announced that a 25% tariff would be placed on an additional $250 Billion worth of Chinese goods being imported to the US. This tariff levying once again shocked markets and sent them trading lower the following week. Although we follow these developments daily it is important to understand the impact that this political risk has on your investments.

Measuring The Effects Of The Trade War

Trade tensions, specifically tariffs, affect the economy and market in a number of different ways. Certain aspects of a ‘Trade War’ are relatively easy to quantify but most are difficult to predict exactly what the long term affects will be. One of the dynamics of tariffs that is relatively easy to quantify is the effect they have on corporate profit margins. According to Empirical Research Partners, the tariffs administered in 2018 decreased S&P profit margins by 2%. This number can be increased now that the amount of goods being penalized has increased. Profit margins are one of the most important factors affecting stock prices so any negative affects to profit margins will translate over to stock prices. Tariffs also affect GDP. The graph below provided by TD Bank illustrates the incremental effects that increasing the amount of goods subject to tariffs has on GDP. Although Q1 2019 GDP of 3.2% was strong, part of this could be contributed to rising inventories. One reason companies may be increasing inventories is to brace for an increase in the cost of imported goods...

The S&P 500 telecommunication sector is getting a new look. For years, the telecom sector has been one of the smallest sectors in the S&P and dominated by two names; Verizon and AT&T. This fall, the telecom sector will be replaced with a new sector labeled as the ‘Communication Services Sector’. As the name implies, the new sector will be more geared towards the way that media is now delivered to customers such as streaming and downloads. Morgan Stanley Capital International, typically abbreviated MSCI, summarized the new sector on their website:

“The last several years have seen an evolution in the way we communicate and access entertainment content and other information. This evolution is a result of integration between telecommunications, media, and internet companies. Companies have further moved in this direction by consolidating through mergers and acquisitions and many now offer bundled services such as cable, internet services, and telephone services. Some of these companies also create interactive entertainment content and aggregate information that is delivered through multiple platforms such as cable and internet, as well as accessed on cellular phones.”

The new sector will be comprised of names pulled from the Information Technology, Consumer Discretionary, and the old Telecom sector. In addition to AT&T and Verizon, the top 10 holdings in the new Communication Services Index will include three of the four FANG stocks – Facebook, Inc. (FB), Netflix, Inc. (NFLX) and Google parent Alphabet Inc. (GOOGL). The other notable holdings include Disney (DIS), Activision Blizzard (ATVI), Comcast (CMCSA), and Charter Communications (CHTR). "The index has 26 constituents with a total market cap of $2.35 trillion, average market cap of $92.5 billion and median market cap of $34.9 billion as of May 16, 2018," said S&P...