Coronavirus Triggers Our Dynamic Hedge

Coronavirus Triggers Our Dynamic Hedge

Today, based on the elevated stress in the markets, as evidenced by the heightened level of the VIX Index, we initiated our dynamic hedging strategy. This is where more volatile holdings are temporarily replaced with less volatile assets during times of great market volatility, as measured by the VIX index, to reduce market risk. To quickly recap, this strategy is not an attempt to time the markets, but is based on volatility data the market provides, and the normal reaction of the most volatile assets when fear takes over. This tactical strategy is strictly defined and will only affect a few holdings. Our studies behind this strategy can be read in the International Journal of Financial Management or the Journal of Investment Management and Financial Innovations.

The fear driving markets is based on the coronavirus, specifically COVID-19, and the potential impact it may have on global growth. COVID-19 is a new virus that was first detected in the central city of Wuhan in December of last year. It was reported to the World Health Organization on New Year’s Eve, and since then has dominated headlines largely due to its infection rate.

It’s worth noting that the virus is linked to a family of viruses known as “coronaviruses” and is part of the same family of viruses responsible for:

  • SARS (Sever Acute Respiratory Syndrome – 2003) — 774 deaths in 2002-2003
  • MERS (Middle East Respiratory Syndrome – 2012) — 2,499 confirmed cases and 861 deaths since 2012
  • Some cases of the common cold. 

COVID-19 seems to be more easily transmitted than the SARS virus, but less deadly. So clearly the infection rate is exceptional. While China reports that it’s stabilizing, there are reasons to remain concerned:

  • First, it’s suspected that infections are being under-reported because testing facilities are under severe strain.
  • Second, China clearly has an economic motivation to limit the scope of the conversation around this to prevent further economic instability
  • Third, it’s well known that the incubation period is 14 days, which allows for a stealthy spread by those who are unaware that they are carriers.

China is working with the US pharmaceutical company Gilead to develop an anti-viral vaccine, based largely on Gilead’s previous work on Ebola and its success with other coronaviruses like MERS and SARS.  They’re currently in the initial phases of clinical trials with a drug called Remdesivir.  

The World Health Organization has not declared the virus a pandemic yet, but the disease has spread beyond China to South Korea, Japan, Malaysia, Italy and Iran. Cases have also been reported in Austria, Spain, Croatia and Switzerland. Fear of the COVID-19 virus infecting the US is intensifying. At last check, COVID-19 has infected 82,550 people worldwide and has claimed 2,810 lives.

The coronavirus will have a negative impact on global growth, especially in China. Though the Chinese government is busy trying to reopen factories, manufacturing in large areas of China has been crippled. As the world’s second largest economy, accounting for nearly 20% of global GDP, and the world’s largest exporter, significant interruptions in manufacturing will be felt outside China’s borders and place strains on supply chains around the globe. The disruption to supply chains is currently very difficult to determine, but the longer it takes to contain the virus, the larger the impact will be. The long incubation period is making containment more difficult.

Besides the loss of output from China and the supply chain disruptions, another negative for economic growth is the extent to which people self-isolate and avoid public places. The impact will have its greatest effect on restaurants, retailers and areas that rely on tourism.

It is important to note that, in past epidemics, the impact of markets has been temporary. The table below highlights some examples:

At this point we don’t know how this will play out, but historically markets have performed well despite past outbreaks. Therefore, though we are initiating our dynamic hedging strategy to reduce market risk in portfolios, we caution against making any significant allocation changes that could keep investors from meeting their long-term financial goals.

I need to give credit to Matt Clarke, our Client Portfolio Manager who co-wrote this blog.

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

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