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Covid-19 – how does it compare to other economic shocks and what it means for investors? 

Covid-19 – how does it compare to other economic shocks and what it means for investors? 

By Nick Sargen, economist and lecturer at University of Virginia Darden School of Business

Over the past five decades, the global economy and financial markets have been buffeted by a series of shocks that have posed challenges for investors. The genesis was the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s that spawned high inflation. In the past three decades, inflation and interest rates were low, but a series of asset bubbles ensued.

In my book “Global Shocks,” I present a framework to assess these shocks. It can be used to analyse the coronavirus shock even though it differs from previous ones.

Diagnosis: An Evolving Pandemic

The framework first assesses the nature of the shock.  Some are straightforward and easy to identify. Others, however, may change over time. For example, the Asian Financial Crisis and Global Financial Crisis (GFC) began as small problems but morphed to become much larger ones.

The latter is true of the coronavirus shock. It was first detected in Wuhan, China, in December and then spread. U.S. markets ignored these developments, even when the Chinese government quarantined parts of the country. Many investors believed the impact would be limited outside China, comparing it to the outbreak of SARS in 2003.

U.S financial markets finally reacted in late February, and then with a flurry. Over the past two weeks, markets were in near free fall amid news that a price war over oil had broken out. This meant the global economy was being buffeted by simultaneous shocks. Since then, markets have been besieged by the World Health Organisation declaring the COVID-19 outbreak a global pandemic, and President Trump declared it a national emergency.

Realisation among investors that the outbreak is likely to worsen has heightened worries about recession risks. As travel is being restricted and major segments of economies are being shuttered, there is growing realisation that the U.S. and global economies are entering recession. Indeed, some forecasts now call for the U.S. economy to plunge at more than a 10 percent annualised rate in the second quarter, which is a steeper decline than during the 2008 global financial crisis.

Policy Response: Can Officials Get Ahead of the Curve?

Once a crisis unfolds, the most important thing to get right is the policy response.  The key issues are whether policymakers know what to do to ameliorate the situation and whether they can act decisively.

The steep market sell-off indicates that the U.S. government was slow to contain the virus initially. Now, more decisive actions, including extensive travel restrictions and quarantines, are being implemented. But they will take a major toll on the economy.

Over the past two decades, investors have become conditioned for the Federal Reserve and central banks to ease monetary policies aggressively to contain the fallout of crises. This time, however, interest rate cuts have been ineffective. The main reasons are they were very low to start, and they cannot counter the direct effects of a pandemic.

This does not mean central banks should do nothing. The goal in providing liquidity to markets and announcing measures to provide safeguards for the financial system is to ensure there is no repeat of the global financial crisis.

Meantime, attention has shifted to fiscal policy. It can be used to target businesses that are being impacted by the virus and to put money in the hands of people. President Trump signed legislation that provides paid sick leave and family leave for some U.S. workers and expands unemployment assistance.  Efforts are now under way to put together a larger relief package that could total $1 trillion.

The main challenge for policymakers is that the spread of the coronavirus will dictate the economy’s performance. As the extent of the economic downturn becomes apparent, further measures will be required.

Market Response: Moving at Warp Speed

One of the core tenets of investing is that market participants must assess what information is priced into markets. Prior to the selloff, the U.S. stock market did not appear to be a bubble, and investors believed the global economy was on the mend and there was clear sailing ahead.

These expectations have been shattered by recent developments. As the economy rolls over, Wall Street analysts are just beginning to reduce profit forecasts for this year, which are likely to be decidedly negative.

Beyond this, it is difficult to discern what is being priced into markets. Stock market volatility rivals the 2008 financial crisis, and the abnormal daily gyrations do not reflect changes in underlying fundamentals. Rather, price movements have been magnified by the prevalence of algorithmic, computer-based trading.  This is similar to the impact “portfolio insurance” had during the October 1987 crash.

Portfolio Positioning: Investors Get a Second Chance

One of the main challenges in investing during crises is that portfolio diversification may not offer adequate protection. The reason: Correlations among risk asset classes gravitate to one. This is what has happened over the past four weeks.

Unfortunately, the sell-off was so swift that most investors could not protect themselves.

One of the main findings from my book is that investors who suffer during a market downturn get a chance to recoup losses when markets rebound. This was especially true after the 2008 financial crisis. Because it is inherently difficult to time markets, an appropriate strategy for many investors is to stay close to their strategic asset allocations and ride out the storm.

One comfort in these scary times is that the impact of the coronavirus is likely temporary rather than permanent. Indeed, the worst of the crisis already is past in China and South Korea, mainly because they took strong measures to contain it. While the worst is likely ahead for the U.S., efforts now underway to contain the coronavirus will hopefully pay off later this year.

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