A widely accepted paradigm in markets is that no fundamental nor technical model can really account for unmeasurable uncertainty. Mathematicians refer to these instances as the error term (an unexplained factor). As the degree of uncertainty heightens, this leaves markets with a sense of void, lack of direction and most of all lack of visibility on the fundamental impact. All this led to a decline in the Eurostoxx 50 by 9.79% and S&P 500 by 10.03% during the last trading week.

The biggest jump has been the VIX index (fear index) as it rose by 191% year to date which puts the recent Tesla share rise to shame. In the traditional asset class space, Treasuries have been the big winners, as it puts them (potentially) into an overbought territory as the two-year stands at 0.93% and the 10 year at 1.16% from the prior 1.60% 14-days earlier, assuming that a recession is averted in the US. 

Most market exponents pre-Covid-19 spoke vividly on the V-shaped economic recovery, especially in European economies. Make no mistake, economies were well positioned to gradually return to normality as headline risks relating to the US-China trade tensions subsided with positive knock on effects on earnings growth. The drastic measures opted by health officials to contain the spread of the virus has spooked investors as this disrupted the business value-chain. 

At first, investors focused on the supply-chain, however, both quarantine and lockdown in China had a direct impact on the demand-chain, as well as, consumer sentiment which is a prerequisite for business activity. The presumption is that health authorities need to work in concert with economic officials to properly assess the economic impact of any decision taken. Basically, health authorities need to understand that any decision taken has an economic cost. Is a recession the price to pay to contain the virus? If not, then health officials need to deal with the virus differently, smartly and strategically. In other words, identify the problem, diagnose the problem with incoming new information and reduce as much as possible the fear factor if the virus is deemed to be less aggressive than initially feared. 

As the spread of the coronavirus widened in Wuhan, China during January; market reaction remained relatively muted except when Chinese markets re-opened following the lunar New Year. Consensus stood solid on the fact that the virus will be temporary and China will enact a series of stimulus measures that will jumpstart any perceived slowdown. China, being the second largest economy in the world with robust economic pillars, provides for a strong fundamental backdrop that has both the capacity and ability to support its business environment. Market perception remained focused on the fact that the virus would remain contained within the Asian region. 

Unsurprisingly, the globalised nature of today’s world economies led to the virus to spread much faster than initially anticipated. Indeed, during the weekend of 22nd February, Italy registered its first cases of the virus. This re-dimensioned the market’s view on the virus and its impact. The first cases of the virus in Europe changed the scale and magnitude of this economic shock. The virus came at an inflection point for European economies and the timing couldn’t have been worse. Markets know that Europe is in a weak economic state with limited economic policy headroom, especially in countries that are highly indebted with a budget deficit that provides none other than a restrictive policy framework. 

This puts the European Central Bank in dire straits as the capacity to provide monetary stimulus is non-existent in a yield environment which puts all the German yield curve below 0%. Astonishingly, if you lend the German government for 30 years, you would have to pay instead of receiving c. 0.15% annually. Surely, this extreme case is an eye opener for the ECB to act swiftly as Europe is threading a fine line into collapse. The only monetary option is that of a monetary stimulus through quantitative easing, which has barely moved the needle in the real economy since its introduction in 2015 throughout the Eurozone.

This leaves fiscal policy, i.e. tax cuts and increased government spending, as the last resort for countries to support their economy. Economically weak nations like Italy would be difficult to implement, but other nations like Germany can do much more to drive their economy by loosening their tough stance on debt and deficit levels. This would prove pivotal for Europe as a whole, given the sheer magnitude of the German economy relative to most nations. Last Friday, Fed chairman Jerome Powell, assured markets that a rate cut is in the cards to provide the necessary cushion for the business fallout due to the novel coronavirus. Currently, markets are pricing-in a (100% probability) 25bp rate cut on March 18, 2020. 

A fair argument is, how will a rate cut be effective in an environment where people are simply concerned to go out and spend? The tendency in such health events is that individuals stay at home and reduce their net spend by increasing their savings rate. Nonetheless, a rate cut would provide a sense of relief for companies, much needed confidence boost for markets and an ‘insurance’ cut for the US economy. 

Going forward; markets expect policy clarity, willingness of significant strategic support by policy makers, visibility by health officials on containment action and changes in stance towards the virus that qualms the overriding fear that puts consumers and businesses minds at rest. The cost for this health hazard with the mortality being so low is too high for directing economies into a nosedive in productivity, higher unemployment, wage deflation, and endangering the overall economic stability that policy makers have worked hard to achieve over the last decade. This extreme scenario of a recession would backfire for Health authorities as the psychological/health impact of a recession will be far greater than the infectious levels observed by Covid-19.

Disclaimer: This article was issued by Jesmar Halliday, CFA, investment manager at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.