Investors are understandably shell-shocked after the extraordinary recent turbulence in markets, which saw US stocks fall almost 30 per cent from their high point in February to their close on Monday. Yet despite the near-certainty of a global recession, the fear looks overdone.
This is not just because equity valuations are no longer so dangerously stretched. The key to stabilising markets in the face of coronavirus lies in the policy response and it is clear that politicians and central bankers are beginning to take the measure of the problem.
On the monetary front, the US Federal Reserve’s package of measures on Sunday was far from paltry, with the target range for the federal funds rate lowered by one percentage point to a range of 0 to 0.25 per cent, and asset purchases of at least $700bn promised. The Fed is also preparing a range of policies to support the flow of credit to households and businesses.
It is not short of ammunition. James Knightley, chief international economist at ING, points out that the Fed’s balance sheet peaked at $4.5tn in early 2015, equivalent to about 25 per cent of US gross domestic product. Today, the balance sheet is about $4.3tn or around 20 per cent of GDP. To get back to 25 per cent would imply balance sheet expansion of more than $1tn. That is hardly small potatoes.
The European Central Bank’s stimulative measures looked disappointing by contrast and were not helped by president Christine Lagarde’s inept suggestion that it was not the central bank’s job to align eurozone governments’ borrowing costs. That is about as far from the rhetoric of her predecessor Mario Draghi as it would be possible to go. This nonetheless served to underline the difficulty of addressing a crisis when the deposit rate is already negative, while highlighting the crucial role of fiscal policy in such circumstances.
Here the news is positive, with German policymakers — hitherto dyed-in-the-wool fiscal conservatives — committing themselves to do whatever it takes, in effect, to ensure that businesses and households are protected from the economic consequences of the virus. That is quite something. The French, Italian and Spanish governments are moving in the same expansionary direction, all of which reflects the very different politics of crisis management when compared with 2008. It is, after all, much easier to persuade the public of the case for using taxpayers’ money to confront a public health catastrophe than to justify putting a safety net under bankers who have done their best to wreck the global economy.
Also good news is the extent to which risk is no longer as seriously mispriced as it was earlier in the year. The search for yield has for the moment been reversed. This was conspicuously true last week in the high-yield bond fund sector, which saw the second largest outflows on record, according to data provider EPFR Global. There were also significant outflows from emerging market bond and equity funds.
In the midst of this flight to quality, fragility in the banking system appears a much lesser concern than in 2008. Share prices are down, reflecting the squeeze on profits that will result from lower interest rates, but the credit default swaps market is not sending storm cone signals. While there were sharp falls in the leveraged loan market last week, much of the damage will have fallen on non-bank financial institutions. And the Fed’s recent emergency funding for short-term borrowing markets has probably mitigated what could have been potentially lethal liquidity shortages among hedge funds.
Pension funds offering defined benefits will be the big casualties of the market slide. Their liabilities will be squeezed by the flight to quality as lower bond yields reduce the discount rate applied to future pension obligations, causing the liabilities to balloon. The fall in the value of equities and risky credit and alternative investment categories will hurt their assets. That said, equities are delivering a higher income from which to pay pensions, as long as companies maintain their dividends.
In defined contribution schemes, people nearing retirement have cause for concern since their funds will have shrunk. The market shock will, incidentally, provide a good test of diversified growth funds, which claim to offer equity-style returns at a lower risk than in the equity market at large. The longstanding question of whether such funds really can smooth returns and offer a free lunch to investors may find an answer this year.
Is it time to look opportunistically at equity markets? So much about coronavirus remains unclear that this would require bravery. But the worst-hit sectors of the market look oversold.
Get alerts on Equities when a new story is published