The storm before the tsunami

To say it has been a wild market ride today would be an understatement. Based on daily data back to 1985 (a total of 9179 observations) the 7.7% decline in the FTSE100 is the fifth largest correction in recent history, beaten only by double digit declines in the wake of Black Monday in 1987 and two days of correction in October 2008 as the Lehman’s fallout continued to reverberate. The 7.9% decline in the DAX was also the fifth largest correction in the German equity market although the US correction did not even make the top 10.

I have been through a few market corrections in my time, and each of them was triggered by a unique set of circumstances. Today’s moves, however, were only partly initially related to equities. They were triggered by the 30% collapse in the oil price following Saudi Arabia’s decision to launch an oil price war and were exacerbated by coronavirus concerns. The Saudi decision came after Russia refused to join OPEC countries in extending existing production curbs in a bid to drive oil prices higher and the Saudis are clearly trying to force the Russians back to the negotiating table. This is bold and risky strategy. Whether or not it works, the shock decline in oil prices put initial pressure on the oil majors and triggered a broader market selloff at a time when sentiment was already extremely nervous. Momentum effects then took hold as equities competed to go ever lower.

Faced with this kind of environment, there is nothing anyone can do but stand back and watch the carnage unfold. Interest rate cuts will be of no real help, even though the Fed, ECB and BoE are likely to deliver additional monetary easing before the month is out. Policymakers can perhaps impose bans on short-selling or impose circuit breakers on the market which will temporarily limit the downside but they are on the whole powerless. The flip side of the equity selloff has been the surge into safer havens such as government bonds and gold, with the US 10-year Treasury yield falling to a new all-time low of 0.5% and the 10-year German Bund trading at -0.86%, implying that investors are so keen to preserve their capital that they will accept a negative return on their holdings of sovereign German debt because the expected loss of principal is greater than the negative yield on Bunds. Without wishing to be too gloomy, a lot of countries are now apparently at much greater risk of recession than perhaps we thought a week ago.

In the face of an equity correction of today’s magnitude, it is easy to extrapolate into the future and make the case for further huge declines. But much depends on the nature of today’s shock. If it merely represented a kneejerk reaction to the oil collapse which got out of hand, markets could easily rebound a little in the near-term. But if it reflects concerns about the impact of the coronavirus on the wider economy, which is more likely, I would expect a lot more downside before we reach the bottom. I noted in this post that the US market had the potential for another 10-20% downside. The market is already 7% below where it was when I wrote that, and as the number of non-Chinese virus cases continues to increase, the potential for economic disruption continues to grow.

The fiscal response

With monetary policy all but exhausted, governments will have to step up to the plate to deliver measures to support the economy. We will have a great chance to see what the UK government is made of when it delivers its post-election Budget on Wednesday. Much of the very good pre-Budget analysis prepared by NIESR or the IFS has now been overtaken by events. It was originally planned that this would be a Budget which attempts to deliver more spending, particularly for those regions which have been left behind by austerity. This was to be a reset of policy – the so-called “levelling up”. But now it will be dominated by efforts to limit the impact of COVID-19.

There are essentially three areas that the government will have to address: (i) ensuring liquidity-constrained businesses can continue to operate; (ii) providing support for individuals who lose income and (iii) maintain the delivery of public services. There are various things the government can do: In the case of (i) more generous payment terms in areas such as employer social security contributions would help to limit the burden (e.g. a payments holiday whereby firms do not have to pay contributions for those workers who are sick with the coronavirus). To tackle issue (ii), the government could reduce the time it takes to get access to Universal Credit payments (as I argued here) and addressing (iii) might involve significant increases in the budget for the National Health Service.

As the IFS points out, in fiscal years 2008-09 and 2009-10, the government’s fiscal expansion package was equivalent to 0.6% and 1.5% of GDP respectively. That is a high benchmark but the UK does have the fiscal headroom to try something similar today. Other governments across Europe will have to follow suit. The German government, for example, has previously dragged its feet but there are indications that it is now prepared to boost spending to support companies which apply for aid to offset wage costs during labour layoffs. As the UK examples cited above show, fiscal policy does not necessarily have to take the form of big infrastructure spending programmes: tweaks to the tax and benefit system can provide much more targeted help.

The time for waiting is over with action required to at least prepare the economy for the worst case outcomes. There is after all, no point in the likes of Germany continuing to run surpluses for the sake of it. We should welcome any moves towards fiscal easing. For too long, governments have been absent from the fiscal policy fray and have left it to central banks to manage the economy. Whether it will mark the start of a more targeted approach, or whether we will soon revert to a period of retrenchment remains to be seen. But whatever else governments do, they must act soon. If nothing else, markets will ultimately punish them for failing to act.