Today I explain why the Coronavirus is killing markets, and will almost certainly demand central bank and treasury interventions that will in the next few months create buying opportunities. (Click on that link to read the column or AFR subs can click here.) Excerpt only:
The inherently unknowable nature of the coronavirus (COVID-19) is creating widespread global market failure, as demonstrated by the highly disorderly 5 per cent drop in US equities overnight Friday (including an extra hour of trading via the US equities futures market).
This has brought the total equities correction to date to more than 12 per cent, with much more downside lying in wait as the newsflow is bound to remain negative.
At the same time, we have seen the primary new-issue bond market starting to shutter, which will make it increasingly difficult for global businesses (ie, corporates) to refinance their debts. The only safe havens are arguably the large global banks, which can tap both government-guaranteed deposits and unlimited central bank liquidity.
This is a classic case of "market failure" flowing from extreme information asymmetries. Economist Ken Arrow won the Nobel Prize in economics for showing, among other things, how imperfect information can give rise to market closures or severe illiquidity as participants are forced to make the worst possible assumptions about pay-offs given their inability to properly judge them.
We saw a great deal of this during the global financial crisis when liquidity evaporated as participants refused to trade because they did not understand the risks they faced and could not, therefore, price them. This ultimately led to central banks stepping in and restoring order.
We’ve internally built data science systems that track infection and mortality rates across the world in real time with 15-minute updates. A crucial test for determining the severity of the COVID-19 crisis was whether the three new outbreak countries – South Korea, Italy and Iran – could emulate China’s alleged success in containing the disease.
On the basis of the information available to us, it appears they have failed, and the epidemic is becoming a global pandemic as the US Centres for Disease Control and Prevention (CDC) and our own Prime Minister recently hinted.
The exponential growth in global infections outside of China, driven by South Korea and Italy, lends weight to this hypothesis. And under-reporting and/or the inability to detect infections means the true global rate at which the disease is spreading is likely to be materially underestimated.
We know that South Korea has been vigilant in seeking to test for infections and publicly disseminate this data. At the time of writing, it had recorded 1766 cases with only 13 deaths, which implies a case fatality rate (CFR) of 0.7 per cent.
This is broadly in line with both the global ex-China CFR and the empirical experience within mainland China, exclusive of Hubei. The South Korean trajectory also implies there are much more serious outbreaks in Italy and Iran than they are officially reporting.
Whereas South Korea has had 13 deaths, Italy and Iran have reported 17 and 26, respectively. And yet Italy and Iran claim infections of only 650 and 270 people. The implication is that the CFRs in Italy (2.6 per cent) and Iran (9.6 per cent) are too high. It is likely that under-reporting and/or poor detection capabilities has a role to play here, which in turn suggests that the outbreaks are materially worse than we believe.
Another problem is that the policy of containment, which is currently the only viable political option, effectively throws the economic baby out with the bathwater, crushing economic growth in the interim. This is being compounded by the so-called financial accelerator and market failure, which is amplifying fear and anxiety, and limiting access to credit, exacerbating the real economy impacts.
That sounds like an awful lot of very bad news. There are three powerful mitigants.
First, a vaccine will be developed in the next 12 months (human trials have already begun). Second, there is likely to be an effective anti-viral drug available within six months with human trials now being completed in China. And, finally, there is evidence that the virus struggles to spread in warmer climates, with just one case in South America, few in Africa or south-east Asia, and clear containment in Singapore and Hong Kong. There is hope that as with the flu, COVID-19 will fade during the northern hemisphere’s summer.
That means that for the next three to six months, global central banks and treasuries will have to provide markets with a liquidity ladder to ensure they remain open and functioning and do not shutter in a manner that would send the global economy into a death spiral.
From a policy perspective, that probably means some rate cuts to support growth coupled with more extensive liquidity and asset purchase operations (quantitative easing, or QE). If ever there was a case for temporary QE to help markets bridge extreme information uncertainties until a vaccine is available, this is it.
It is likely the US Federal Reserve will cut rates by 25 to 50 basis points in March and expand its QE initiatives. The ECB will follow suit by further boosting the QE that it is now targeting at credit markets through direct corporate bond purchases.
As a small open economy with China, South Korea and Japan as its largest trading partners, Australia cannot avoid the fallout. This will necessitate the government setting aside its 2020 surplus target with the RBA supporting the ensuing fiscal stimulus with rate cuts and perhaps its own government bond-focused QE to put downward pressure on the Aussie dollar, which will assist externally facing industries.
When all is said and done, the current fear and anxiety will translate into a tremendous buying opportunity because COVID-19 has no real ramifications for the long run. That time has, however, yet to arrive.