The brutal correction in financial markets in recent days reflects both the level of investor complacency prevailing last week and the great significance of developments on the coronavirus front.
Whereas, just a week ago, investors were regarding COVID-19 as being predominately a Chinese issue, it is now understood to be a fast-spreading global concern.
Coronavirus kills the ‘V’-shaped recovery
The globalisation of the coronavirus is a game changer. The recognition that the virus is globalising has extinguished hopes of a “V”-shaped recovery in global growth and rekindled fears of recession. When the coronavirus was largely contained to China, consensus expectations were for a “V”-shaped recovery in global growth, based on the expectation of a relatively swift containment of the virus and an energetic policy response from the Chinese authorities. The geographic broadening of the COVID-19 has undermined this scenario, given growing doubts about the effectiveness of containment measures outside China and the scale and speed of policy stimulus measures.
The situation with the coronavirus is so fluid that efforts to quantify the epidemic’s potential economic impact are highly speculative. One thing that is clear is that the outlook for the global economy has darkened significantly in just a week. Disruptions to normal economic activity are spreading fast across many countries and the constant flow of troubling new developments is undoubtedly going to weigh heavily on consumer and business confidence. It is hard to avoid the conclusion that we are facing many weeks of growth downgrades and earnings disappointments.
There has been plenty of news on the coronavirus this week; almost all of it has been troubling. The number of confirmed cases has surged in countries outside of China, most notably in Italy, Iran and South Korea. The virus is now present in 56 countries, compared to 26 just a week ago. Beyond this, scientists are uncovering a number of ominous features of the virus. Not only do we now know that the COVID-19 virus can be spread by people who are showing no symptoms of the disease, but we have also learned of a number of cases of people testing positively for the illness a second time, having previously considered to have recovered from the virus.
What’s priced in?
The unusual lack of visibility on the economic outlook complicates efforts to work out what is now priced in to financial markets. What’s clear is that market purge of the past week has priced out all hopes of a “V”-shaped recovery in global growth. Although market moves have been huge, they are only commensurate with a rapid de-risking of bullish investor positioning as sentiment has swung from complacency about the global economy to gloom. This week we have seen one of the most rapid adjustments of investor sentiment in the history of financial markets. Still, a global recession is by no means fully priced in nor can we say that markets yet reflect systemic concerns about the health of the global financial system.
Whereas equity markets and commodities are the best barometers of investor confidence in the growth outlook, credit markets are the place to watch for evidence of systemic stress in the global financial system. Credit spreads have naturally widened this week, to reflect the general repricing of risk. Still, they are nowhere near pricing in a global recession nor do they they reflect meaningful investor concerns about the resilience of the global financial system. While $7 billion of assets has been pulled out of high-yield bond funds this week, $11 billion has flowed into more defensive investment grade bonds. Credit markets are showing heightened investor fear but not panic. Credit will be a key area to watch if the global sell-off continues, given the potential for more rapid withdrawals from credit funds to intensify financial and economic stresses. In credit markets, sentiment can become fundamentals.
What will it take for markets to recover?
In just a week, the burden of proof has shifted from the bears to the bulls. Investor sentiment about the global economic outlook is now so damaged, that some sort of good news is now needed to make the case for a sustainable recovery in risk assets. As things stand, it is hard to see a path to convincingly good news on the coronavirus front in the weeks ahead. The virus now has such global momentum that things seem certain to get worse before they get better and they might get very much worse.
In the near term, there is probably more scope for policy intervention to stabilise market sentiment than anything that will be found in the coronavirus data. Central banks are undoubtedly going to start cutting rates very soon. Still, they do not have much ammunition at their disposal as the virus is a real economy shock that will not be easily solved by monetary means. Fiscal policy has more scope here but it is far from clear that the global response on this front will be quick enough or big enough to offset the broadening adverse impact of the coronavirus on economic sentiment and activity.
Paul O’Connor, head of UK-based multi-asset team at Janus Henderson Investors
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