After spending much of the last decade in abeyance, fear has returned with a vengeance to the markets. Rattled traders returning to their desks on Monday will be braced for more volatility after last week’s sell-off in global equities, the largest since the depths of the financial crisis in 2008. Mounting concerns at the rapid spread of the coronavirus caused one of the quickest market corrections in the benchmark US S&P 500 since the Great Depression in the 1930s.
The speed of the decline in equities suggests there may be reasons for a bounce in the coming days but it also highlights that markets had been riding for a fall. Investors, used to an environment of persistently low interest rates and cheap money from central banks, had grown complacent and were ignoring the mounting signs of an economic slowdown. Equities, in particular US technology stocks, had begun to look overvalued. A revision was overdue even before the outbreak of the coronavirus. The market rout has been amplified by the increasing dominance of passive index funds as well as algorithmic trading.
Previous sell-offs in response to a global health epidemic provide only so much insight into where markets are headed. A recent assessment of the market impact of past outbreaks by JPMorgan, including Sars and swine flu, found that a sharp initial stock market decline quickly gave way to a recovery. There is no certainty that a similar rebound will happen this time. There are fresh concerns that the risks of a global recession are mounting. The yield on the US 10-year Treasury note dropped below 1.2 per cent on Friday for the first time to hit 1.167 per cent as investors sought safe havens. Goldman Sachs has warned that profits at US companies will stagnate this year.
The coronavirus outbreak — and the world’s policy response to it — are creating a negative shock to both supply and demand that will reduce growth. Strong consumer activity has underpinned the US and eurozone economies. Restricting travel, closing schools and isolating whole communities will have an inevitable effect on spending.
Given already low borrowing rates, monetary policy is limited in what it can do to sustain weakening demand and to prevent liquidity problems. Christine Lagarde last week played down the chances of the European Central Bank providing an imminent response to the virus. Mark Carney, outgoing governor of the Bank of England, meanwhile said Britain should prepare for a downgrade in economic growth. The Federal Reserve on Friday signalled it was prepared to act.
Despite the constraints, policymakers may need to deploy non-standard monetary policy tools. South Korea’s central bank last week decided not to cut its benchmark interest rate but noted that a more effective response at this stage was targeted support for sectors and companies most affected by the virus.
An area of focus should be the credit markets and upcoming debt rollovers. Corporate debt has soared over the past decade. A first test could come as soon as the start of June when some $200bn worth of debt is due to mature in the sectors most exposed to a slowdown. Airlines and travel groups in particular are worried about losing business during the summer season.
The longer-term economic fallout remains the big unknown. The number of new cases in China appears to have dropped but in Europe and elsewhere they have kept rising. The worry is that the market rout will turn into a credit crunch. If that looks likely, policymakers need to show they are ready to take decisive action.
