The latest financial motto rings true: “The stock market is not the economy.” Since the spring of 2018, we have narrowly avoided a global recession, shrugging off a vast array of both geopolitical and economic obstacles. Plus, with the latest Chinese economic data: a record low in the Composite PMI reading, it’s likely to get worse before it gets better as the Coronavirus wreaks havoc on economies worldwide. Yet, the bull market in stocks continues, unabated.
However, the biggest bull market headwind occurred last week when global stock prices plunged over 11.5%. Everyone, from the media to Wall Street, jumped to the conclusion that Coronavirus fears caused the crash, but there was a problem: the virus had already spread globally, weeks before stock markets tumbled.
Between the 17th and 20th of January, 2020, China, United States, Nepal, France, Australia, Malaysia, Singapore, South Korea, Vietnam, and Taiwan all reported cases of the Coronavirus, yet stock markets climbed. On January 30, the World Health Organisation (WHO) declared coronavirus a global emergency, yet stock markets climbed. On February 15, the Chinese death toll had reached 1,500, yet stock markets climbed. All this time, safe-haven assets rallied reflecting the economic reality, behaving as you would expect, yet stock markets climbed.
Clearly, something was wrong. With fear rising and most markets adjusting to what could be a global recession, why were stocks still climbing to all-time highs? The Coronavirus explained sentiment in other markets — bonds, commodities, currencies — but it failed to explain the stock market crash.
While virus fears became the leading narrative behind why stocks were plummeting, the true catalyst hit breaking point deep within the global financial system.
Starting in September 2019, credit dried up completely in the interbank lending markets: a key part of the monetary system where banks trade overnight loans known as repurchase agreements — or repo for short. Suddenly, lending rates spiked to 10.5% in a matter of minutes, a rate not seen since the Global Financial Crisis (GFC). Large funding costs indicated that primary dealers: major financial institutions hand-selected by the U.S government were hoarding collateral. No one wanted to lend.
If the Federal Reserve refused to intervene then turmoil was imminent in liquidity-dependent markets such as stocks and high yield debt. So Fed Chair, Jerome Powell, issued a statement saying the central bank would provide primary dealers with — on average — $75 billion dollars a day to help with liquidity issues. This new money had to go somewhere and the stock market was the recipient. Every trading day for a period of six months, the Fed remained active in the repo market, and stocks continued to reach new, all-time highs.
Over this period, the Coronavirus has spread worldwide. Every major country had a confirmed case of the disease. But while the headlines read “virus fears,” under the surface, the crash’s catalyst was triggered: Just like before the Lehman Brothers collapse, the Fed pulled the rug from the carpet by reducing its repo operations causing a liquidity panic, and stock markets started to plunge: -3.35% on Monday, -3.03% on Tuesday, -0.38% on Wednesday, -4.42% on Thursday, and -0.82% on Friday, as liquidity vanished from the global financial machine.
The way markets reacted to a sudden loss of stimulus revealed the truth about the crash: the virus distracted investors from a liquidity event that had burst the mini-stock bubble. A black swan, hidden from the public eye. But the virus narrative made it worse, turning a scare into a panic by pairing illiquidity with extreme fear. Safe havens like the Japanese Yen and US Government bonds reacted and went into full “risk-off” mode except for precious metals that crashed more than 5% instead of receiving a huge bid as you would expect. Liquidity became so scarce that hedge funds had to liquidate their tangible assets to pay for big stock market losses.
The situation, however, became even stranger. In response to the stock market crash, global officials — even in the fields of health and science — were as concerned about restoring market sentiment as they were about saving lives. WHO director, Adhanom Ghebreyesus, said to CNBC, “Global markets … should calm down and try to see the reality,” while President Trump also tried to save markets from further pain using Twitter, “… CDC & World Health have been working hard and very smart. Stock market starting to look very good to me!”
Central banks and global financial institutions are also pledging to do everything in their power to keep stock markets afloat which, if left their own devices, will keep falling fast. There are many approaches officials can employ to try and alleviate stock market pain: Although the Federal Reserve Act prohibits buying stocks they could revert legislation if needed. They could lower the discount rate allowing struggling banks to spur more lending. And, if all else fails, they could take extremes measures: slashing interest rates to zero and relaunching quantitative easing.
The authorities are not only on virus watch but are also on bubble watch as they know if the Coronavirus causes an economic collapse, the death toll from a societal upheaval could be just as bad — if not worse.
So with the global officials’ willingness to create an even looser monetary environment that’s already dirt cheap, prevailing sentiment has created a V-shaped recovery narrative where all bad economic outcomes simply don’t matter. The global stock rally must continue; to support peak baby boomer retirements, to support a presidential campaign that relies on a stock market boom, and to support the millions of retail investors who piled into equities hoping that they would rise indefinitely.
As the virus continues to spread, supporting asset prices will require a level of market intervention we’ve never seen before. We’re about to witness the biggest debt expansion in history, blowing any response to previous global disasters, whether World War II or the Great Depression, out of the water. The biggest bubble ever requires the biggest amount of debt to let the party continue.
The question, though, is whether extreme monetary and fiscal easing is enough to stop a further stock market collapse. In the past, loose conditions failed to prevent a sharp decline in stock prices during both 2001 and 2008 recessions until the market fell enough to what price discovery considered fair value, and by that time stock prices dropped more than 50%.
But there’s a bigger issue at bay: while officials continue to issue more and more monetary and fiscal stimulus in an attempt to save stock prices, it will fail to curb the effects of the Coronavirus, because, after all, you can print your way to economic growth, but you can’t print your way to a vaccine.
