Economic textbooks teach us that markets hate uncertainty. It introduces volatility in prices of financial assets and, for investors who have been on the rollercoaster of fluctuating uncertainty, the reward only comes if uncertainty disappears. Based on the behaviour of markets since the start of the year, one is tempted to conclude that textbooks need to be rewritten. The week which saw rising tensions between the US and Iran saw markets closing higher. Later on in January, the coronavirus caused a dip on Wall Street but since then new records have been set. Does this make sense or is it an illustration of extreme complacency? The very muted and short-lived reaction to the rise of geopolitical tension early January reflected a view that the risk of escalation was very small, something which was confirmed by the limited retaliation by Iran.

The reaction to the outbreak of the coronavirus is tougher to explain. After all, there is broad agreement that the impact on Chinese growth will be bigger than under the SARS epidemic in 2003, when in the second quarter GDP growth dropped 2% on an annualised basis versus the quarter before, from 11% to 9%. In the third quarter growth was back at 10%. The impact on the global economy should also be bigger, considering that in the past 10 years, about 25% of global growth comes from China. The hit to tourism is another channel of global spillovers. Finally, there is also the impact on the supply side of the economy, with concerns that car plants in Europe would have to stop production because of lack of spare parts coming from China. Nevertheless, Wall Street has made new all-time highs and indices in Europe have also done well. One factor which plays a role is distance, or more precisely, the view that the fall-out for US or European companies should, on average, be rather limited, certainly compared to what happens in China. Unsurprisingly, equity indices in China and Hong Kong are still down since the start of the year. The reference to ‘on average’ is a reminder of the necessity to be nuanced in the assessment: sector effects are big as well as company-specific effects, depending on the exposure to China as an export destination or as an input in the global value chain. Interestingly, commodity prices (oil, copper), after seeing a considerable decline, have barely rebounded. US treasury yields are still lower compared to the levels before the virus outbreak. This suggests that concerns about growth are still very much top of the mind of investors in certain asset classes.

The behaviour of US and European equities could also reflect the view that before the epidemic, business surveys were actually improving somewhat, creating an expectation that the quarterly pace of growth would pick up as the year progresses. Looking at the epidemic as a temporary shock, it underpins a view that, firstly, within several weeks, we will hopefully move back to business as usual and, secondly, that should it turn out that the epidemic lasts longer than expected, with the ensuing detrimental effects to confidence and growth, there would still be time to adjust positions, meaning to sell equities. In a nutshell, this line of thinking reflects a shortening of investment horizons. Low interest rates play a role here and create a ‘fear of missing out’, that is of missing the equity rally.

 

First published in the AGEFI Luxembourg  February issue