Commentary: Novel coronavirus reveals old vulnerabilities in the global economy
The novel coronavirus has the potential to become a big enough shock that reveals the weaknesses of central banks and sluggish global growth, says Mohamed El-Erian.
NEWPORT BEACH, California: Last week’s fretting over the coronavirus was a good illustration of a tug of war that has been playing out in financial markets for a while: Between favourable sentiment and mounting longer-term economic uncertainties.
Until now, at least, that contest has been resolved in favour of ever-higher stock prices.
But investors need to decide if they want to opt for more of the same, by continuing to implement an investment playbook that has served them well, or if they want to treat the viral outbreak for what it is — a big economic shock that could derail global growth and shake markets out of their “buy-the-dip” conditioning.
Entering 2020, investors faced the challenge of balancing favourable short-term market technicals with weaker fundamentals, and doing so with government bonds providing little protection given the very low — and, in some cases, negative — level of yields in advanced countries.
The coronavirus outbreak amplifies two vulnerabilities: Structurally weak global growth and less effective central banks.
It is becoming harder for markets to treat such fragilities as being beyond the immediate horizon, especially with a host of other uncertainties not far behind, including the recurrence of trade tensions, growing realisation of the impact of climate change, technological shocks, political polarisation and changing demographics.
Retail, trade and travel are simple ways to illustrate what is going on in China.
Stores are facing dramatic disruptions involving a virtual halt in traffic, while suppliers are finding it harder and slower to move their merchandise, both within and in and out of the country.
And there is a huge drop in travel to China, dealing another blow to economic activities undermined by less internal mobility.
This virtual stoppage of economic activities is cascading throughout the second-largest economy in the world, and one with considerable regional and global ties. It is fundamentally weakening the country’s services sector, at a time of considerable challenges for manufacturing.
With both engines of growth now sputtering, internal and external, China will also find it harder to navigate its transition from a middle-income economy.
The country’s increasing “sudden stop” economic dynamics also involve adverse spill-over effects, first and foremost for emerging Asian economies with strong economic and financial linkages with China.
A weakening China is also a problem for Europe, where the European Central Bank is effectively out of productive ammunition and politicians are yet to implement a comprehensive pro-growth policy package.
And with the virus affecting the movement of people and goods, there is an increased risk of a multi-year process of de-globalisation that neither the global economy nor markets are wired for.
The coronavirus also has the potential to constitute a structural break for markets: A big enough shock that fundamentally shifts sentiment.
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NEW GAME PLAN
Previously, markets had been underpinned by the belief that central banks were always willing and able to repress volatility and boost asset prices. That fuelled investors’ fear of missing out on a seemingly never-ending rally.
Until last Friday (Jan 31) when US stocks dropped about 2 per cent, markets’ inclination was to respond to sell-offs by deploying a game plan that worked well in 2019 and early 2020, including in response to shocks such as the US missile attack that killed a top Iranian general and the disruption to half of Saudi Arabia’s oil production.
For the previous year, traders and investors quickly bought every dip in the belief that the latest shock would prove temporary, contained and reversible.
Now, the multi-year gap between elevated asset prices and weaker economic conditions is becoming increasingly unsustainable.
The global economy and markets are getting closer to the neck of a T-junction. What comes after that involves a stark contrast, depending on how policymakers respond.
One way involves recession, financial instability and even more complicated politics; the other, a genuine growth process that validates elevated asset prices in an orderly fashion and opens the way for more constructive politics.
If investors still insist on immediately buying dips, they should do so in a much more differentiated manner by favouring higher-quality issuers that are underpinned by strong balance sheets.
They should also avoid swapping US assets for more international exposure, which — although more attractively valued — is much less resilient to global economic weakness.
For the remainder, which is probably most investors, they should consider that this latest shock to fundamentals could prove severe enough to dislodge for a while the bullish market conditioning that has been so critical to this historic stock rally.
Given that the negative economic effects of the virus are yet to be sufficiently absorbed by markets, this also calls for much greater immediate attention to potential vulnerabilities in portfolios, in the form of equity and liquidity risk.
Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge