These 3 dubious assumptions about coronavirus explain market plunge

These 3 dubious assumptions about coronavirus explain market plunge
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This week markets began to reflect alarm about the novel coronavirus outbreak. Investors sold off stocks and bought safe bonds, driving bond yields to record lows. These moves raise questions: What brought on the pessimism? Why now, when we’ve had stories about the virus for weeks? And what comes next?

Given the difficulty of explaining investor psychology, it can be easier and more fruitful to turn the question around: In the face of a potential pandemic, what did investors have to believe in order to be as optimistic as they were before this week? And equity markets were and remain very optimistic. At its high-point last week, the S&P 500 was up over 20 percent from its level a year ago. Even after the early-week drops, the index was still up over 10 percent for the year — at a time when real GDP growth was just 2.3 percent in 2019. 

Here are three dubious assumptions that were underpinning the prior market confidence:

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  1. The novel coronavirus outbreak would be contained.

This was the assumption that took the biggest beating this week. Earlier, the outbreak had seemed to be predominantly situated in China, emanating from Wuhan in Hubei province. While there were notable outbreaks beyond China, they had seemed limited and directly traceable back to Chinese contacts. There were extraordinary efforts to contain the virus around its point of origin, including placing roughly 50 million people under quarantine. 

This week it became increasingly clear that containment had not worked. Significant outbreaks were reported in South Korea, Italy, Iran and elsewhere. A U.S. public health official warned that Americans should prepare for the disease to spread across the country. 

Public health experts warn that should the outbreak become a global pandemic, we will move from a containment response to mitigation. It is less clear how exactly this would work; there are substantially more global interconnections than there were in the last major global pandemic, in 1918. 

  1. The macroeconomic effects of the outbreak would be minimal. 

Under the containment assumption, many economic forecasts called for a V-shaped recovery. First quarter GDP in China and elsewhere might well take a hit as factories were slow to reopen after the Chinese New Year break, but extra activity in the second quarter would replenish inventories and the net impact would be minimal. 

Both the broader scope of the infection and the public reaction to the outbreak cast doubt on this assumption. While some economic activity can be readily deferred and carried out later – such as a car purchase – it is less likely this will happen with cancelled vacation cruises or major business conferences

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Some of the more optimistic estimates for the United States relied on the relatively small share of U.S. sales that go to China. This underestimates other key modes of economic transmission: Other countries facing outbreaks; supply chain interruptions; and a potential hit to consumer psychology. 

Finally, predictions of a rebound – whether V or U-shaped – rely upon companies surviving the downturn. If, instead, the prolonged stop in economic activity drives Chinese firms out of business, this will significantly inhibit a recovery. 

  1. Should anything go wrong with assumptions #1 or #2, central banks would set things right. 

A significant source of support for soaring equity prices has been the prevailing era of loose monetary policy. Nominal policy interest rates have been low in the United States, zero in the Euro Zone and negative in Japan. Real interest rates – taking inflation into account – have turned negative even in the United States. These policy rates reflect a prolonged period in which central banks did step in to try to cure economic ills.

So why would that not continue? Two reasons. First, there are limits to how much a central bank can do. While it has proven possible to push interest rates below zero, doing so takes a toll on the banking sector. Central banks may have largely exhausted their ammunition. 

Second, unlike in recent years, there are now signs of inflation. Were China to attempt to extend substantially more credit to its firms, it would risk inflating a debt bubble and stoking a bout of inflation — historically anathema to central banks. 

The interconnectedness of these assumptions sheds light on why some news stories about infections in Daegu or Lombardy could set the financial world on edge. Once the containment assumption falls by the wayside, the other lines of defense begin to look less robust. It remains to be seen whether this realization will puncture the broader optimism that has driven equity markets to their recent highs.  

Phil Levy is chief economist at Flexport, a freight forwarding and customs brokerage company based in San Francisco.