Looking through the market turmoil

The coronavirus outbreak is set to deliver a sharp and deep economic shock. Market moves are reminiscent of the 2008 crisis, but we don’t think this is a repeat. Stringent containment and social distancing policies will bring economic activity to a near standstill, but provided aggressive fiscal and monetary policy actions are taken to bridge businesses and households through the shock, activity should return rapidly with little permanent economic damage.

The market’s gyrations have sparked memories of 2008. Developed market stocks have fallen as much as 27% from the February peak, but pared losses on Friday.

The magnitude of the selloff is similar to that in the aftermath of Lehman Brothers’ bankruptcy in 2008. See the chart above. We have also seen sharp swings in fixed income, with U.S. Treasury yields first hitting record lows and then closing up on the week. Crude oil prices last week posted their largest single-day decline since the Gulf War amid a price war between Russia and Saudi Arabia. What will it take to stabilize markets? A decisive, preemptive and coordinated policy response is key, in our view. This includes aggressive public health measures to stem the outbreak, as well as coordinated monetary and fiscal easing to prevent disruptions to income streams – especially to households and smaller firms – that could cause lasting economic damage. We see encouraging signs on both sides of the Atlantic that such a monetary and fiscal response is underway.

The evolution and global spread of the coronavirus outbreak are highly uncertain. What we know: Containment measures and social distancing mechanically bring economic activity to a halt, as seen in China and Italy. There is a strong incentive to enact such measures proactively to slow the growth of coronavirus infections, and France and Spain over the weekend joined Italy in imposing drastic lockdown measures. The impact on economic activity will likely be sharp – and deep. Yet we believe that the sharper the containment measures taken and the deeper the economic hit in the near-term, the more confident we should be about the rebound after such measures are lifted. We see the shock as akin to a large-scale natural disaster that severely disrupts activity for one or two quarters, but eventually results in a sharp economic recovery.

The key assumption behind this view: Policy makers act to stabilize economies and forestall any cash-flow crunches that could lead to financial stresses and tip the economy into a financial crisis. The Fed on Sunday cut rates to near zero, announced up to $700 billion in bond purchases and other measures to ensure the proper functioning of markets, and set up arrangements with other central banks to make U.S. dollar funding available. The White House earlier unlocked disaster funding, and Congress is set to pass a bill to cover health care and paid leave for some workers. A more sizable fiscal response is possible amid growing recognition in Congress that this is needed. The UK last week delivered on a coordinated set of measures including a Bank of England rate cut and a budget that included relief to affected sectors. This, and similar moves by Canada last week, is the type of coordinated monetary and fiscal action that we have flagged a need for in dealing with the next downturn. The European Central Bank provided material relief to the banking system at the heart of financing the euro area economy, and several European nations signaled they will significantly loosen fiscal policy. Yet the ECB’s move was not the “whatever it takes” package markets had expected, and bond yields of some peripheral nations jumped.

We have recently downgraded our stance on risk assets to benchmark weight due to material uncertainties associated with the outbreak and its impact, including the effectiveness of public health measures and how long the threat of the virus will linger. Large declines in yields have further diminished the cushion that government bonds have to offer against risk-asset selloffs, reducing their portfolio diversification benefits. We still prefer U.S. Treasuries over lower-yielding peers for portfolio ballast, but acknowledge increasing risk of snapbacks from near historically low yield levels.