Short and Sharp: I’d prefer a vaccine over a rate cut
Global equity indices have erased all their year-to-date gains, entering correction territory of 10% losses in the space of just four days. U.S. Treasury yields have plummeted below previous record lows, the German bund yield curve has sunk back into negative territory across its entirety, while gold has leapt to new highs – becoming the preferred safe haven for many investors.
That markets have failed to register even a slight rebound on any single day since the sharp sell-off since the start of the week is a meaningful concern. Typically, after such a move, the market would rebound for at least a few days as investors take the opportunity to buy the dip. The fact that this reaction has not materialised suggests that caution and fear is reigning strong and, with the negative turn in coronavirus news flow outside of China potentially in its early stages, further drops in risk assets cannot be ruled out.
Adding to downward pressure on risk assets has been the fact that U.S. and European stocks had jumped to fresh record highs just last week, failing to appreciate the extent of coronavirus-related economic risks and inflaming already stretched valuations. With risk assets so overvalued, they were already very vulnerable to negative news flow — and, oh my, this news flow has been concerning.
With infection rates in some countries now mirroring the early pace of infection in the doomed Diamond Princess cruise, and the daily number of new coronavirus cases outside China now exceeding those within China, investors and households alike are now asking: is the rest of the world where China was at the end of December – the very preliminary stages of a devastating epidemic?
As governments and companies look to curb travel and large gatherings in order to contain the virus, fear of the potential impact on the global economy is surging. To the extent that it damages confidence across the globe, prompting people to stay at home and triggering a sharp drop in consumer spending broadly, the immediate demand impact could be sharp. At the same time, further prolonged disruption to global supply chains has the potential to play even greater havoc on the global economy.
Inevitably, eyes are turning to the old-age saviour: the Federal Reserve. Markets are now pricing in at least two Fed rate cuts, starting as early as April, while there is growing expectation for accelerated easing from the European Central Bank and other developed market central banks. Asia, Thailand, Malaysia and Indonesia recently cut policy rates by 25 basis points, while the Bank of Korea is expected to cut 25bp at its upcoming meeting.
It surely won’t take too much more negative economic data and infection news to prompt the Fed to deliver the rate cut the market is pleading for. But at this stage, how much help can additional rate cuts really offer?
The ECB, BOJ and several other central banks have rates already in negative territory, while the Federal Reserve’s rates are higher but standing only 150 bps above zero. Markets are already enjoying remarkably low borrowing costs, so the effectiveness of further monetary policy cuts is questionable.
More pertinently, is monetary policy really the best tool to help against a respiratory infection that inflicts the most worrisome part of its economic devastation via the supply side?
No matter how much the Fed cuts rates and stimulates consumer demand, it cannot eradicate the need for quarantine and travel barriers to arrest the spread of infection. Therefore, with workers unable to travel to work or even get hold of masks that may enable them to work in communal spaces, factories will continue struggling to return to full capacity. Stimulating demand is almost useless when global supply chains are disrupted.
Of course, once the virus has stabilized and supply chains are once again functioning, lower policy rates can help facilitate the recovery, encouraging companies to produce more products in order to meeting growing demand. But, until the number of new infections drops, monetary policy simply is not equipped to trigger the V-shaped recovery markets had originally been anticipating.
What else is on the horizon?
Depending on the potential headroom available, fiscal policy is likely to take a more front-line role in in limiting longer-term economic damage by providing offsets for businesses and workers, such as tax-free waivers or even cash handouts, in order to alleviate cash flow pressures. Governments in China, Hong Kong, and Malaysia have already started these provisions, fiscal authorities in Italy are actively investigating their options, while even Germany has decided to temporarily suspend debt limits.
It seems then that the epidemic, almost a pandemic, is accelerating the role reversal between governments and central banks that had started to get underway at the end of 2019.
Yet, unfortunately, even fiscal policy does not fix the contagious features of the coronavirus, rendering it also ill-equipped to fight the supply shock. Ultimately, with neither central banks nor governments able to provide markets with the one element that could sustainably and effectively prop up sentiment, an affordable and workable vaccine, markets may simply need to wait till there are clear signs that the virus has peaked and is being contained.
The highly uncertain game of “wait and see” is wholly unsatisfactory guidance for investors, so let’s make some realistic assumptions to help create something of a market outlook.
Given the two weeks it may take for coronavirus symptoms to show up, it seems fair to expect the number of cases to increase further over the coming two weeks. During that time frame, news-flow is likely to remain decidedly panicky and, in that case, markets may not have yet found their floor despite having hit correction territory. Further drops are possible so investors should resist the urge to buy the dip.
Traditional safe havens are uncomfortably expensive. Yet, if cases continue to multiply sharply and governments have little choice but to introduce draconian measures of quarantine, US Treasury yields can fall further and gold can hit new heights.
Look for the silver lining. These times are uncertain, and there is no guarantee except that this episode will eventually end – leaving markets notably cheaper. Having some dry powder to deploy when the situation eventually bottoms will, at some point, be your key consideration.
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