The contrast between the awful humanitarian crisis in China and the euphoria in global stock markets had been bordering on the surreal. Every night (London time) the Chinese authorities updated their count of the number of new infections and the number of people that had already died from this horrible virus. Every night (London time), the US stock market hit new highs (much to the President’s delight). So why, after initially freaking out about the situation in China, not to mention the potential spread of the virus to other parts of the world, have investors basically been ignoring this risk? The question is important, not least because there is no guarantee markets will continue to react in this way.
There are three reasons:
First, the official statistics suggested the situation in Wuhan, the epicentre of the virus, is improving - or at least getting worse at a slower pace. Investors have also taken heart from the fact that very few people outside of this province have actually been dying from the illness. The problem, of course, is that these statistics look entirely bogus. Not only has the number of testing kits restricted the official coronavirus count, but there are also reports vast numbers of people have been excluded, sent home, or simply massaged out of the public record. The latest revisions have only muddied the picture further but since the daily ‘delta’ continues to decline, investors still have a good excuse to focus their attention on something else e.g. totally out-of-date macro data.
Second, market participants say they are ‘looking through’ the short-term effects of the coronavirus – i.e. the massive hit to Chinese demand – and focusing on the policy response. Whereas the authorities were prepared to tolerate lower growth in 2020, it is now clear they will be willing to stimulate their economy in a big way (once it reopens for business). This is probably correct, but it includes a really important assumption - that the authorities can quickly contain the virus and immediately get their huge industrial sector back up to capacity. Given the huge seasonality in Chinese macro data, the next few weeks will be critical. If the factories do not reopen soon, we will not only know that the statistics on the virus were bogus (because the infection isn’t contained) but we should also expect serious supply disruption to the rest of the world. Chinese "value added" is crucial to international supply chains. Foreign producers were prepared for China’s New Year, but continuing closures would clearly catch them out.
Third, we should remember stock markets are not particularly good at pricing these sorts of extreme tail risks. In a memorable blog a few years ago (well, I remembered it…), Gavyn Davies gave a convincing explanation for why equities behave in this way, arguing it reflects the cost of buying insurance against extreme risks, which leads to ‘discontinuities’ and ‘tipping points’ in asset prices. Investors will ignore low-probability dangers for extended periods, only to react in a discontinuous manner once the threat passes certain thresholds (or becomes especially imminent). While it is popular to blame “central bank liquidity” for this market trait (like all things in finance), it is also something we saw before the days of QE – which is why hard-core bears on Twitter like to remind us that stock markets ignored the rise of Adolf Hitler, or sleep-walked through the threat of nuclear war. The other issue, which Gavyn Davies did not cover, is the growing dominance of algorithmic trading. You have to wonder how AI incorporates extremely subjective and unknowable risks.
In short, we really can’t take much comfort from the fact global markets have been shrugging off the situation in China. While equities might be right to assume a temporary SARS-like hit to global demand, there is a great deal of uncertainty about this forecast. Remember uncertainty and risk are not the same thing. With risk, investors know roughly the probability of different outcomes and are prepared to make bets on a specific scenario (esp if their probabilities are different to the rest of the market). With the coronavirus we simply have no idea which odds to place on different outcomes. This requires a degree of humility and careful monitoring of the situation. And, of course, if we start to see much greater incidence of the virus outside China - frankly it too early to know if this will happen - the global economic outlook would look pretty different to the simple v-shaped it-will-only-affect-Q1 everyone is expecting.
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