Wealth Management: Strategy blog – Market contagion
Strategy team - Kevin Gardiner (Wealth Management)
Stocks have fallen sharply further in the last few days as consumers, companies and governments respond to the spread of covid-19 outside Asia. Safe haven assets have extended their gains, with longer-dated US bond yields dropping to new all-time lows.
Business survey data from China have fallen sharply, to lower levels even than in 2008 (though seasonal effects at this time of the year can be pronounced). It seems inevitable that harder data - sales, output, profits, GDP - will also be hit hard, and in Europe and the US too. If controlling contagion means stopping people meeting, then it means stopping a lot of business.
There is some discussion as to whether this is a supply or demand side shock, but the main point is surely that both are being hit: changes in inflation expectations are of secondary importance (though they have softened too). The prospect of the next recession - which seemed to be receding at the start of the year - has moved closer again.
It is not possible to know when the response will moderate - and for the time being, it is the response, not the illness itself, that is hitting the economy and markets. Another complicating factor is that this lengthy cycle has been a deeply unpopular one, and pundits have not been slow to see the outbreak as hastening its demise.
Recessions can hit employment and profitability hard, if temporarily. Perhaps the key question for us as investors is whether the risk posed by a virus-inspired downturn now is worse than that posed by a "normal" one.
The initial downturn in output and sales will doubtless expose those businesses whose cashflow is thinnest and leverage highest, and their failures could hit overall liquidity hard. But there have been relatively few macro excesses in this cycle - banks and consumers have not been lending and borrowing recklessly - and these spillover effects may not be any larger than usual. It is too soon to talk of another financial crisis (and the fall in stock prices on its own does not yet constitute one). It is also too soon to talk of the end of “globalisation”, even as the airports empty.
Set against this, there is less room than usual for interest rates to fall now (though the Fed at least is now widely expected to cut interest rates again soon). Even if rates could fall a long way, in the context of travel restrictions, contagion controls and consumer fear, their impact would surely be less potent than usual.
Fiscal policy of course has more room to respond, but again, outside the immediate relief and control spending, it may not do much in the face of such constraints. Should it even try?
We suspect that a recession - which could yet be avoided - on this account might be less potent than one needed to correct consumer or inflation excesses.
This is admittedly a new virus, and its fatality rate of reported cases around 3% (likely biased upwards) is worse than some others'. But we think that at some stage, people will recognise that the risk of contagion can never be eliminated, that the threat of a pandemic is always with us, and business will resume - in many cases as abruptly as it may have fallen. Many transactions will have been permanently lost, of course; but some will have been postponed, and others, like the household goods being stockpiled and additional government outlays, would otherwise not have happened.
The speed with which stock markets have fallen - having previously seemed to ignore the threat - is unsettling. When both would-be sellers and potential buyers revise their estimates lower, adjustment is brutal. As we write, global stocks are down 11.5% in dollars (13% in euros, 10% in sterling) from their 19th February peak. That was an all-time high, however, and in December, before the outbreak, we'd thought that markets might have been tactically a little ahead of themselves.
Faced with this alarming bolt from the blue, then, our advice as patient investors remains to sit tight and wait for more clarity on contagion and fatality rates. We suspect that long-term prospects are not likely to be significantly damaged by the outbreak - though we cannot prove it of course - and that the public mood and stock markets may be over-reacting. As a result, we remain more inclined to look for eventual opportunities than to follow markets lower.
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