Summary: There is speculation that the Coronavirus pandemic will lead to a global recession. Indeed the bearish price action in commodity and stock markets indicates that there is trouble ahead for the global economy.
The sharp sell-off should be seen as the markets adjusting to the exponential reality of a pandemic past its containment. The structure of modern asset markets is such that in the short to medium term, liquidity inflows and outflow drive asset prices. Fundamentals matter less in the short to medium term. In the long term fundamentals do cause mean reversion to economic reality but going by data from past flu pandemics such as H1N1 – a vaccine will likely be ready in the long-term or the pandemic will resolve.
The current correction in asset markets can therefore be seen as a pullback in the liquidity driven structural bull market that started in 2009 and not a bear market indicative of a looming global recession. The chain of quantitative easing announcements by central banks across the world (“the liquidity vaccine”) has in fact made higher stock valuations more viable in the long run.
Remember the H1N1 flu was declared a pandemic in 2009 – but the markets kept rallying due to a deluge of Central Bank Liquidity in late 2008.
Let us study reactions in different markets to see the role of liquidity –
Commodity Markets: Crashing commodity prices are one of the indicators of recession. Crude oil prices have crashed, other essential commodity prices such as Steel, Sugar and Soybean have also crashed. However these corrections are not entirely due to market forces but due to cartel price cuts in case of Oil and long unwinding.
Long unwinding happens when funds (such as hedge funds) that were net long on sugar futures, for instance, have liquidated their positions competitively to cause sugar prices to cascade down.
In case of rare supply constrained commodities like Arabica Coffee however, the coronavirus pandemic has actually led to a rise in its global price. This is because Funds were not long on arabica beans – so the prices were determined by demand and supply and not speculation.
Stock Markets: Stock Indexes hit historical lows with consecutive circuit breakers last seen only in 2008. However a lot of panic selling was triggered by the exponential spread of the virus in the US and should be seen as a “pricing in” of sudden bad news.
The markets are an amazing discounting machine but they are not perfect in their reading of the future (i.e semi-efficient). A viral pandemic that is now post containment in parts of Europe and threatens to cripple the world’s largest economy had therefore to be suddenly priced in with the news of deaths in NYC, the financial center of the world.
How did the markets react? A historic crash in the S&P due to sudden unwinding of ETF long positions and also due to the cascading effect of stop losses being triggered due to algorithmic selling. Again – Liquidity driven.
However after last week, the pricing in and discounting of most of the bad news should be behind us. In fact the CBOE Volatility Index or VIX is a reliable indicator of peak pessimism and a market bottom and the VIX was close to 2008 levels towards the end of last week. A bottom may be formed in the week ending 20 March. The highly leveraged banking and financial sector that led to the 2008 recession is also largely intact and the top US bank are reporting good numbers – ruling out a repeat of a systemic financial crisis.
Bond Markets: With the crashing stock markets, the flight to safe havens produced a sharp rise in the 20+ Year U.S. Treasury Bonds. However the spike did not last long and has since been selling off since the global stock market rally on Friday the 13th, supporting the idea that money is moving back into stock markets.
Indian Markets: In India – where there is no liquid alternative to US Treasuries (GSecs are not very liquid and are not traded by retail investors), the flight to safety therefore saw flight of money to marquee FMCG stocks like Nestle that trade at extremely high valuations. But like the US Treasuries – their prices corrected during the late pullback rally on Friday the 13th, as money moved back from safety into quality stocks available at historically low valuations. The crash has been largely driven by FPI and FII selling – foreign money withdrawing from Indian markets – however domestic investors have been net buyers in this crisis.
The Indian NIFTY Index is still 500 points from hitting the lows of demonetization of the rupee and may find support next week and make a bottom. Demonetization was a deflationary event but currently the Indian economy is better placed with inflationary global environment, historically low Oil prices (as a net crude importer) and a low dependence on global trade. In fact, Indian exports have a low base and can grow double digits just by gaining market share even if global trade grows in low single digits due to the coronavirus (“base effect”). These past few years have also seen structural reforms such as corporate tax and income tax cuts giving a boost to corporate earnings and domestic consumption.
The biggest risk for Indian Markets finding support at demonetization levels remains the Coronavirus spreading beyond containment – an incident that may not yet have been priced in.
Conclusion: Central bank fueled liquidity is the foundation of modern market structure. Central banks must use this “dry powder” of quantitative easing sparingly. Black swan events like the coronavirus force their hand to support the economy of G-8 nations that is not backed by real economic growth.
Unlike 2008, the banking and financial system is also largely intact ruling out a credit and systemic financial crisis, which is a larger existential threat to leveraged economies than a temporary GDP based slowdown caused by the coronavirus.
The modern economy, like the stock market is addicted to “easy money” and has received its flu-shot, perhaps the strongest since 2008. A sustained bear market triggered due to the coronavirus may therefore be ruled out.