Just as some people overestimate their own physical condition while others tend more toward hypochondria, market sentiment can also sometimes be emotionally way out of line with fundamental reality and just as often much worse than would be justified by the economic situation. Discrepancies between the economic findings and the perception in the markets are thus the rule rather than the exception. Because the first one is always blurry or rather delayed and sometimes also distorted by external, non-economic factors. However, in view of risk investments around the globe being severely affected by the highly infectious coronavirus, the question of the (direct and indirect) real economic impact is currently of central importance, since every turning point on the stock markets must sooner or later be reflected by the fundamental economic trend and vice versa.
First thing to note: within three weeks, the major stock indices lost around a third of their value in the fastest correction in stock market history, even faster than in the 1930s. The recent upheavals have therefore created good buying opportunities for investors who are not too focused on short-term performance, provided that the sharp recession triggered by the coronavirus pandemic is limited to the next two to three quarters and does not evolve into a multiyear depression. A chronic divergence between markets and fundamentals is unsustainable, they must eventually move back into line with each other. And although there is hardly any doubt about the former from today’s perspective, the latter is fortunately still an unlikely, extreme scenario.
But let us go back a bit. The uptrend in global equities has lasted for an above-average eleven years, hardly or only briefly interrupted by technical corrections. In a marvelous transformation, the previous mood of doom mutated successively to a chase of new highs, and most investors were always quick to overcome any temporary vertigo. Not without reason: for the first time in the post-war period, the world economy had almost its longest run without a full-blown recession – with at most a harmless slowdown every few years. Looking purely at the long duration of these positive developments, fatigue and signs of ageing had to be expected. But what catastrophic economic syndromes are causing the symptoms recently observed in the markets?
As a general rule, one should not instinctively fear the worst unless there is a very good reason to. This is by no means intended to embellish the current, alarming situation, but to put it into perspective in a larger context with the help of somewhat simple financial mathematics. First, stock prices reflect expectations of company success or failure over a very long horizon – the lower the interest rates, the further you look into the future. Even if revenue and profits shut down completely for a few months or quarters before recovering – and a recovery can still be assumed with a high degree of probability – the value of shares should not be affected negatively in the long term, unlike what recent price losses suggest. However, with rock-bottom interest rates, errors in expectations and their corrections (upward or downward) have a more severe impact, making wild price fluctuations – as a reflection of increased uncertainty and difficulties in finding the right direction – an entirely predictable result. Secondly, in view of the expected economic downturn around the globe, many fiscal policymakers have announced new stimulus measures on an unprecedented scale, while all central banks – thirdly – have also been firing from all cylinders in recent weeks to support an ailing economy and to stabilize the financial system.
The baseline scenario, which we view as plausible, is therefore a deep recession limited to a few quarters, followed – perhaps even in the last few months of the current year – by a similarly strong but no longer entirely inflation-free recovery. Similarities to the seven-month recession in 1918 as a result of the Spanish flu would not be entirely coincidental…
However, residual risks can never be completely ruled out: these include the worst-case scenario of a global pandemic with several waves of secondary diseases, claiming millions of lives – as well as a series of irreversibly collapsed economic structures. On the other end of the spectrum, long-term interest rates could rise unexpectedly, which paradoxically would become more likely if an overstimulated yet more resilient global economy ultimately holds up better and starts to recover faster than we assume today. Like in medicine there can be no guarantee as to how long this diagnosis for the financial sector will remain valid, even after a thorough check-up. Intensive observation and, where necessary, rapid action remain an imperative preventive strategy as long as there is so much divergence in our economic prognosis.
Market perception: badly bruised, far from healthy – but the economic findings are less negative.
Dr Alex Durrer
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