S financial markets suffered the fastest 10% correction in history last week. We believe the pace of the market decline was accelerated by forced unwinding of leveraged trading strategies that “short” volatility and therefore depend on low and stable market volatility.
Volatility, as measured by the VIX index in the chart below, spiked sharply at the end of last week’s trading. Similar spikes in volatility over the past years have signaled the end of this forced selling pressure. If that historical pattern repeats, then equity markets could stabilize in the upcoming weeks.
Longer term, we are concerned that a sustained recovery in global equity markets may be almost entirely dependent upon the ability of global policymakers to contain the Coronavirus. Should the virus continue to spread, global economic data could plummet like China’s February purchasing manager survey (see chart below). Global policy makers might struggle to counter such a sharp economic slowdown.
The US is already close to maximum historical levels of stimulus for the three big tools traditionally used to fight recessions (deficit spending, lower interest rates and quantitative easing). With stimulus efforts close to historic highs before the economy has been impacted by pandemic fears, US policymakers may not have much left in their bag of policy tricks to help counter a Coronavirus recession.
After a disastrous start, world leaders and health organizations are beginning to assemble a coordinated strategy to contain the spread of the Coronavirus. These efforts have been hampered by the late start and the fact that people can spread the virus before showing any symptoms. That allowed the disease to spread to many more countries, a fact that has unsettled financial markets.
Even so, assuming we are now getting accurate data from most global governments, the number of new cases remains small when compared to the overall population. We are also encouraged that, as shown in the chart below, the pace of new cases of infection has dropped below the pace of resolved cases where people have recovered from the virus or, in a small percentage of cases, have died.
That means the number of people infected with the virus is declining, despite the headlines.
If current trends continue, then we can hope and pray that the Coronavirus epidemic is being contained and its impact on human lives and financial markets will be limited.
However, these hopeful trends regarding the Coronavirus may not be enough to calm markets. Trust in the data being received from global governments regarding infection rates is low and policy options for countering any resulting economic damage may be limited. For example, Washington policy makers have three big weapons they can deploy to fight an economic slowdown:
1. Run a bigger deficit
2. Lower interest rates
3. Print money and use it to buy financial assets (Quantitative Easing or QE)
As we discuss in more detail below, the problem Washington faces in countering any epidemic related slowdown is that the accelerator is already pretty close to the floor for all three of these policy options.
The US government deficit is projected to be about $1.2 trillion in fiscal 2020, close to the all-time high for the budget deficit of about $1.4 trillion. The $1.4 trillion borrowing level was experienced in 2009 at the height of the financial crises and with unemployment approaching 10%.
Running such large deficits during a period of relatively low unemployment (3.6%) might reduce President Trump’s ability to stimulate the economy should it slow down. Deficits automatically go up in economic slowdowns because tax revenue declines while food stamp and other spending programs increase.
In the next economic slowdown, any meaningful stimulus measures would almost certainly push the deficit well past $2 trillion. Such large deficits could make it even harder for House Democrats and President Trump to reach an agreement on the specific provisions of any stimulus package.
Unlike Japan and Europe, the Federal Reserve has been able to increase interest rates from the 0% level that marked much of the last decade. As a result, the Fed can lower rates from the current range of 1.50% to 1.75% back to 0% if the economy weakens (the Fed has ruled out taking rates below 0%). This 1.50% potential drop in rates contrasts sharply with the 5.0% rate decline the Fed was able to engineer during the 2008 Great Recession. Although better than nothing, we are concerned that such a meager drop in rates will not provide much stimulus to offset an economic slowdown.
Quantitative easing (QE) is the name policy makers give to a strategy of printing money and buying financial assets. QE was a key tool that global central banks used to fight the financial crises of 2008 and the persistently sluggish economic recovery that followed. Unfortunately, as with budget deficits and low interest rates, the US economy has already deployed aggressive QE strategies to sustain its current rate of growth.
The US government runs a $1.2 trillion budget deficit and must therefore sell a large amount of bonds to finance its borrowing. In September of 2019, a key component of this financing process, the “repo” market, collapsed under the weight of the US government’s massive borrowing needs. Rates on repo agreements spiked to 10% and threatened to raise rates across the US economy.
The Fed responded by starting a monthly $100 billion QE program, printing money and buying US treasury bills. Since last September, the Fed has flooded financial markets with over $600 billion in newly printed money. The pace of this QE program already exceeds any of its past QE programs over the past decade (QE1, QE2 and QE Infinity).
Even more concerning, QE may not be very effective in fighting an economic slowdown caused by an epidemic. The 2008 recession was largely driven by the collapse of the housing bubble and all the interconnected financial obligations tied to home mortgages. In response to this housing crises, the Fed printed money and bought home mortgages and long term treasury bonds. These QE purchases forced mortgage rates down, directly benefiting the housing market and US consumers. What assets can the Fed buy to counteract a virus?
Markets are extremely oversold and a short-term bounce should not surprise investors. However, the long-term outlook for stocks may depend more on medicine than economics. If the Coronavirus is successfully contained, then current market volatility may prove to have a long term benefit for equity investors.
The Fed is likely to respond to this volatility and associated economic fears by lowering interest rates when it would have preferred to keep them where they are, in our opinion. More Fed easing would add to the stimulus coming from big deficits and QE, and the bounce back from the Coronavirus scare could be extremely powerful for the economy and for financial markets.
Although we believe that current trends indicate that the virus will eventually be contained, we must acknowledge that global governments have not been consistently forthcoming or transparent about infection rates. The US has maintained its economic recovery by aggressively deploying stimulus tools normally reserved for recessions while Japan and part of Europe may already be in recession.
As a result, the global economy is not well positioned to absorb a sustained shock to economic growth. The consequences should the Coronavirus continue to spread are likely to keep us cautious and financial markets volatile until the epidemic has been clearly contained.