In theory, and all other things being equal, an increase in uncertainty results in a fall in the price of risky assets and an increase in the price of safe haven assets. In a way, this can be considered as the “price of uncertainty”. The reality is rather more complex. Greater uncertainty also affects growth prospects, which in their turn influence asset valuations.

The coronavirus epidemic has triggered a sharp increase in uncertainty and, for over a month, has dominated financial markets behaviour. Thus, the sharp fall in prices for industrial metals and oil reflects expectations of a substantial drop-off in demand, particularly from China. Bond yields have also fallen sharply. The response of equity markets can be split into two phases. Initially, the reaction in the US and Europe was very moderate; after a short drop, markets rebounded and Wall Street hit new highs. The second phase, which saw the spread of the virus to other countries, most notably Italy, triggered substantial falls.

The very divergent behaviours of markets during the first phase stands out. For a number of weeks, the ‘normal’ correlation between US equity prices and long bond yields, which over the years has generally been positive, became negative: equity prices rose and long yields fell. Statistically, this change has been observed before. Since 2010, the moving 30-day correlation has been negative for 26% of the time. On average, periods of negative correlation last for 36 days, but can be nearly twice as long. This was the case in 2019 when the bond market saw a fall in yields, linked to a change in policy at the Federal Reserve and its decision to cut policy rates. The most surprising fact this time around was that the negative correlation came about at a time when China was suffering a major shock from the coronavirus outbreak which, by virtue of the weight of the country in the global economy, will have international repercussions (over the last ten years, China has represented more than 25% of growth in global GDP).

In response, the IMF has cut its forecast for Chinese growth this year from 6.0% to 5.6%. However, it has barely touched its forecast for the global economy (cutting it from 3.3% to 3.2%), whilst adding that it is also taking into consideration scenarios with prolonged and more serious effects on growth, but not making these its core scenario. In short, the revisions are limited and based on the assumption of a short-lived shock. As a result, the ‘temporary’ or ‘prolonged’ nature of the shock is at the heart of investor analysis. In the financial markets, until recently the dominant perception has been that these are temporary shocks, both in terms of uncertainty and the impact on economic activity. Substantial shocks, admittedly, but temporary. On this view, making a round trip between equities and cash in a short period of time would require considerable skill in market timing. Better therefore to ignore this double shock and stay invested, particularly as the background, before the outbreak, suggested a degree of improvement in the global economy: better business survey data, a reduction in uncertainty (US-China trade deal, Brexit) and the support of low interest rates. Clearly, the shift into phase two, with an increase in the number of countries affected, saw this argument give way to a fundamentally different reading of the situation: a health crisis spreading geographically and lasting longer than previously expected. When pricing this uncertainty, it is important to bear in mind the specific features of the current crisis: the fall in demand and disruption to supply result from an exogenous, non-economic shock, in contrast to the cyclical downturns of the past triggered by significant monetary tightening (the Volcker years in the USA), fiscal tightening (the sovereign debt crisis in the euro zone), or balance sheet issues (the sub-prime crisis).

As a result, once the epidemic has passed its peak, markets will already be looking towards a gradual return to normal activity levels, on the view that a temporary, exogenous shock is unlikely to lastingly affect companies’ ability to create jobs and generate profits. Over the next few weeks, it is this view that will need to be validated. Economic data will therefore be scrutinised to assess the scale of the shock and also its duration. The sensitivity of markets to news on the epidemic and the economy can only increase.

Article published on March 5, 2020 on the  Agefi website