- The epidemic caught up with global stocks this week, suggesting investors had clearly misjudged its contagiousness and, just as importantly, the severity of the economic shock. Moreover, central banks appear powerless to deal with the problem
It took exactly a month. Ever since the coronavirus disease, Covid-19, began to move financial markets in late January, equity markets had been remarkably resilient in the face of mounting concerns, and increasing evidence, that the epidemic is disrupting supply chains and snuffing out a tentative global economic recovery.
On Monday, the calm was abruptly punctured. In the worst day for global stocks in two years, the FTSE All-World Index fell 3 per cent as investors took fright at the sudden outbreak of the virus in Italy, and an acceleration in cases in South Korea and Iran.
The S&P 500, having lost 3.4 per cent on Monday, fell a further 3 per cent on Tuesday, its first back-to-back drops of 3 per cent or more since the surprise devaluation of the yuan in August 2018.
As I argued previously, stock markets had been too complacent about the economic fallout from the epidemic. Investors instinctively believed that the impact on growth would be transitory, despite the huge level of uncertainty over governments' ability to contain the outbreak and, just as importantly, the deep integration of Chinese firms into complex global supply chains.
The main reason equity investors initially brushed off the threat posed by the disease was their expectation that leading central banks would intervene if a serious growth scare materialised " an assumption that has proved correct in every major sell-off since the 2008 global financial crisis.
Indeed, judging by the further decline in benchmark government bond yields over the past month " the 10-year US Treasury yield has fallen a further 30 basis points since February 12 to 1.33 per cent, a new low " markets are anticipating another round of monetary stimulus.
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In a sign of the extent to which Covid-19 has emerged as a key determinant of sentiment, bond investors have ramped up their bets on additional interest rate cuts this year. According to data from Bloomberg, markets now expect the US Federal Reserve to trim rates at least twice by the end of 2020, a sharp increase compared with what was priced in at the end of last year.
However, the plunge in bond yields also reflects mounting fears about the health of the global economy, which was in a fragile state even before the virus grabbed the headlines. Not only do hopes of a rapid V-shaped recovery look increasingly forlorn, it is now clear that markets misjudged the contagiousness of the disease and, just as importantly, the nature of the economic shock.
A sudden, and potentially prolonged, interruption in supply chains presents a much bigger threat to the global economy and markets.
While monetary policy can help stimulate demand, it is of little use in dealing with supply disruptions, particularly those caused by an international public health emergency.
Further rate cuts are not going to get Chinese factories back online or help lift quarantines on towns near Milan. While fiscal measures targeted at the worst-affected businesses would be more beneficial, only a vaccine could allay fears and help restore confidence.
Moreover, the ineffectiveness of monetary policy in addressing the fallout from Covid-19 comes at a time when the side-effects of years of cheap money " dangerously distorted asset prices, an excessively large stock of negative-yielding bonds and widening income inequality " are more pronounced, and when investors are questioning the ability of central banks to stabilise markets and boost growth.
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While much of the focus has been on the economic impact of the virus, the consequences for markets could be just as significant, if not more.
Investors have been hanging on central bankers' every word for the past decade. Although monetary policy has lost a lot of its potency, for most traders, it remains "the only game in town" in the absence of coordinated and meaningful fiscal stimulus.
Yet, for the first time since the financial crisis, central banks are powerless to deal with the problem at hand. If fears about the epidemic continue to undermine sentiment, there is a significant risk of markets losing faith in the most important source of support for asset prices.
To be sure, there are other factors that are encouraging investors to buy risk assets, the most conspicuous one being ultra-low bond yields. However, if governments and public health bodies fail to contain the viral outbreak, the impotence of monetary policy will become ever more apparent, fuelling the selling pressure.
On Wednesday, stock markets in Europe and the US steadied somewhat, suggesting that there are still plenty of investors who believe that the virus-induced sell-off was excessive and that sentiment will soon recover.
This has admittedly been the pattern over the past several years. Yet, markets remain liquidity-driven. If the providers of liquidity are perceived by investors to be impotent, the foundations that have underpinned markets since the financial crisis could quickly crumble. Investors play down the threat posed by Covid-19 at their peril.
Nicholas Spiro is a partner at Lauressa Advisory
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