With the markets shell shocked by of the worst weeks on record, analysts are split on whether investors are simply overreacting to the coronavirus epidemic or if we are confronting an actual existential threat to the global economy. While most epidemiologists caution that the virus will be nearly impossible to contain, the good news is that it may be far LESS lethal than many of the contagions that we have comfortably lived with for years. When the panic and uncertainty subside, we may just end up with a new strain of influenza that will harass humanity seasonally, but will not meaningfully alter the course of global economics. But this is not really a story about a new biological disease, it’s one about an old financial disease that is finally becoming symptomatic.
The truth is that the Dow at nearly 30,000 had been priced to perfection and was particularly vulnerable to any surprise “black swan” event, no matter how virulent. In this case, it’s not the size of the pin that is causing the damage, but the size of the bubble the pin has pricked.
Up until the pandemic fears really took hold a few weeks ago, investors were largely unconcerned about the oversized increases that occurred over the prior 14 months. From a low in December 2018 to the high in February 2020, the Dow rose a stunning 35%. While it’s true that this performance began after a sharp sell-off in November and December of 2018, it’s important to recall that those declines were perfectly justifiable given the situation at the time. In October of 2018, yields on 10-year Treasury bonds had surged past 3%, the highest rate in nearly a decade. This forced investors to factor in the costs to over-leveraged businesses, consumers and federal and state governments of dealing with more expensive credit, a reality that had been hidden for years by ultra-low interest rates. It’s not an accident that the decline only ended when investors were soothed by the Fed’s total abandonment of its prior commitments to tighten policy.
Since then, the market has drifted upward sharply, buoyed by every seemingly positive development. Further dovishness from the Fed, in which it ended its balance sheet reduction campaign, injected hundreds of billions into the credit markets, and actively cut rates faster than the markets had predicted were the primary factors. But markets were also helped by some positive (but minor) resolutions in the trade war, and the failures of the Democrats’ impeachment gambit, which made Trump’s 2020 reelection more likely. Negative developments, like the spike in public debt and deteriorating global trade, were ignored.
But the surprise coronavirus, like the spike in long rates in 2018, forced investors to confront risks that were actually lurking in plain sight the entire time. Even if the virus scenario plays out to be relatively benign, the short-term hit to businesses that are increasingly dependent on global supply chains, travel, tourism, and transportation will be showing up very quickly and may likely make a meaningful impact on quarterly results. In a market priced as if nothing bad would ever happen, these questions are proving to be too much to bear.
And it’s not as if the markets are expecting good news to come from other areas. There are no political, diplomatic, or economic breakthroughs that anyone expects anytime soon. Predictably, many investors may be assuming that the Fed will ride to the rescue as it has in the past. The current consensus, according to the Wall Street Journal’s Daily shot Newsletter, is that the Fed will cut rates by a half point by its March meeting, and then follow that with another quarter point or two by September.