9 min read 13 Mar 20
Summary: Two weeks ago, I wrote about how market responses to coronavirus fears – which had initially been relatively muted and discerning – were showing signs of episodic behaviour.
Since then those signs have turned to full blown panic, with correlated declines across most assets and sectors, and oil declines adding fuel to the fire
It is very rare to see such moves and suspect anything other than an overreaction by investors.
And yet, as we noted in the last post, there is evidence that when confronted with totally novel situations, markets can underreact for sustained periods (as outlined in a paper I tweeted alongside the blog post).
Could it be possible that even with the extreme price moves we have seen, that investors could still be complacent about the economic effects of the virus? There are a couple of behavioural reasons why this could be the case.
Instead of looking at each new situation on its own merits, human beings have a tendency to look for similar past events as a guide to how to act.
When the coronavirus first emerged, the points of reference were SARs or Ebola, temporary periods of contained stress which had little long term impact on global economies. More generally the decade-long experience of previous panics being buying opportunities seemed to influence beliefs.
Now, these points of reference have had to be jettisoned. Today the reference point is 2008, with the focus on liquidity and credit conditions, that come with it.
However, this shift of focus has largely been driven by price moves themselves, a natural response given our tendency to talk about scary phases in terms of: “largest declines since…” or “back to the levels of …”
There is always something useful to take from the past. However, from an economic standpoint, there are key ways in which today’s dynamic can differ from recent experience in important ways. Without forecasting these, getting a sense of where the market consensus lies and how it might be surprised can be very important in determining how we should respond (if at all).
For the most part, the consensus view seems to still be that the impacts of the virus will be temporary. This is the case in terms of both the chance of a summer abatement in cases themselves, but also in the hits to global activity.
At face value this rings true. A temporary halt to activity should simply defer growth before a period of catch up, leaving your long term picture unchanged (Aswath Damodoran has analysed this point on his blog).
However there are dissenting voices, which have got more prevalent (or got more coverage) and markets have moved further. The argument here comes back to 2008 echoes; neither indebted companies nor many consumers can survive the halt in activity without support.
In general though, while the majority seem to accept this argument with regard to specific sectors (airlines in particular), the potential for broader long-term fallout is not obviously the base case. This is also true with regards to supply chain disruption. It would be a shock to many if the impacts of the virus were more long-lasting, particularly if this was due to some unforeseen outcomes unrelated to our 2008 experiences.
In recent years, part of the reason that fears of being ‘late cycle’ have proven to be misplaced over lie in the changing structure of the global economy: The correlating impacts of manufacturing in a world of inventory cycles has been replaced in the west by a diversified, service-based, labour force. Globalisation has also meant that it can be possible to source goods from elsewhere when one region has an issue.
This could well be why neither the commodity price collapse of 2015/16 nor trade wars prompted the global recessions that many feared. Rather sharp correlated declines on such fears have often been buying opportunities for growth assets.
In the case of the virus however, the impact clearly strikes at both services and manufacturing, the impacts of which can already be seen (in fact, with the degree of automation in manufacturing today, activity could be more resilient, assuming there is sufficient demand).
The impact on supply-chains also means that globalisation flips from being a supportive factor to a challenge as the costs of interconnectedness outweigh the benefits of diversification.
This is a different, more correlated dynamic than many have been used to. While such issues are unknowable, there is cause to worry if the consensus belief is not a ‘worse case’ scenario but something more benign. This would mean that the scope for a big price move in response to more negative outcomes is arguably greater.
At the moment however, it is hard to see that any form of fundamental assessment is going on. Investors simply want their money back. As Howard Marks wrote at the start of the month, the prevailing thought process seems to be as follows:
Even if the fundamental beliefs of investors are not as negative as they could be, intra-day moves seem to have very little to do with what investors think the fundamentals are, and especially not to do with the compensation on offer for those risks. Investors are engaging in Keynes’ beauty contest, worrying about what other people will think assets are worth, rather than considering the assets in their own right.
All this has made for some strange moves in assets this week. From markets being suspended across the globe as ‘circuit breakers’ are triggered (on both the way up and the way down), to uncertain correlation properties being displayed by government bonds and gold, as well as liquidity issues in the US Treasury market and fixed income ETFs trading at huge discounts to NAV, there is much to make one fear the systemic drivers of prices at present.
As in previous phases around the Financial and Eurozone crisis, the relationship between price and fundamentals as been suspended. Huge stimulus from policy makers around the world, and the positive benefits to the consumer from tax cuts and falling rates have been largely ignored, except in so far as they support liquidity in financial markets right now.
In the early days of the coronavirus many asked whether other investors would be able to ‘look through’ what many thought would be a temporary hit to fundamentals. Today, it still seems on balance that investors view likely economic impacts to be temporary, but very few have been able to ‘look through’ the volatility in asset prices.
Instead, that very asset price volatility seems to have shaped people’s beliefs, making them more bearish on the fundamentals, even without them realising it. We certainly feel this influence, and yet like many others, we profess to believe that it is the fundamentals that are more important over the long term than volatility in prices.
Echoes of 2008 are scary in that they have shown us that price moves can have a real impact if they cause the financial system to cease functioning ‘as it should.’ When the relationship between price and fundamentals breakdown as it seems to have at present it is therefore tempting to jettison our views on fundamentals and valuation. However if there is one area in which the past is informative, it is in making us aware that this is often a very dangerous thing to do.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.