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.

Accounting for tail risks

Today’s announcement by the Fed of a 50 bps rate cut – the first intra-meeting rate cut since 2008 – is an indication of the extent to which it is taking seriously the potential for corona virus-related economic disruption. The die was cast yesterday when the OECD reduced its outlook for global growth in 2020 from 2.9% to 2.4% (chart) – just below the 2.5% rate which is considered to be consistent with global recession. There is little doubt that COVID-19 has left an impression on the Chinese economy during Q1, with the OECD cutting the 2020 growth projection from 6.1% to 4.9%, which would be the third slowest growth rate since 1980. 

It might yet turn out worse: As the OECD noted, “a longer lasting and more intensive coronavirus outbreak, spreading widely throughout the Asia-Pacific region, Europe and North America, would weaken prospects considerably. In this event, global growth could drop to 1½ per cent in 2020, half the rate projected prior to the virus outbreak.” Markets are certainly looking to the downside, with US equities down almost 3% following the Fed’s actions. So much for shoring up market confidence.

Just to put the coronavirus issue in perspective, the WHO’s latest Situation Report suggests that China has recorded 80304 cases out of a population of 1.428 billion. That’s an infection rate of 0.0056%. Based on the reported number of deaths (2946) this implies that (so far) the chance of an individual dying from the disease is 0.0002%. This is roughly a 1 in 490,000 chance which compares with a 1 in 10,000 chance of being involved in a fatal auto accident in China. Obviously the authorities have put in place some draconian measures to restrict movement which has significantly slowed the rate of new infections but which have had significant adverse consequences for the economy.

But without wishing to downplay the seriousness of the threat posed by the virus, it is important to keep the risks in proportion. Much of what the authorities are preparing for in Europe and the US represents the worst case outcomes and it is important to distinguish these tail risks from outcomes at the centre of the distribution. We have, of course, learned to our cost the failure to prepare for worst case outcomes. The failure to identify tail risks ahead of the Lehman’s bust arguably contributed to the severity of the downturn and on the basis of the old adage, “fail to prepare, prepare to fail” it makes sense to take precautions. If such measures save lives they are clearly worthwhile but we must be careful to avoid talking ourselves into a panic. 

The statement by G7 Finance Ministers and central bank governors early today suggested they would “use all appropriate policy tools to achieve strong, sustainable growth and safeguard against downside risks.” It was only a matter of hours later that the Fed decided to act. Whilst the G7 was correct to suggest that greater use of fiscal measures was appropriate, it is questionable how useful interest rate cuts will prove to be. This is not to say they are unwelcome but the fact is that many central banks, including the ECB and BoE, have very little scope to cut, unlike in 2008 when there was plenty of downside for rates. This highlights the point that many of us have been making for some years that failure to normalise interest rates as the emergency conditions of 2009 eased, has left many central banks with little policy space to counteract the next downturn.

Moreover, it is widely accepted that the virus will act as a supply shock, as people are unable to work, rather than a demand shock where interest rate cuts can have more of an impact. To the extent that people’s demand patterns are altered, this is more likely to reflect a conscious change in behaviour rather than a  response to financial conditions. Where monetary policy can be more effective is in ensuring that business cash flow is not affected by a short-term breakdown in activity. Thus central banks may be able to make more capital available to banks by cutting the countercyclical capital buffer, in a bid to maintain the supply of credit.

On the assumption that the virus effects are relatively short-lived, it is imperative that central banks quickly take back their emergency easing measures in order that they do not become permanent. Fed Chairman Powell sidestepped this question at his press conference today, and whilst it is understandable that he does not want to telegraph the future course of policy, it is equally important for the long-term health of the financial system that markets do not continue to live on the fresh air provided by an overly lax monetary policy. In the event that the ECB cuts rates again, which is a realistic possibility, removing the stimulus as soon as is practicable will help to alleviate some of the damage which negative rates are doing to the fabric of the euro zone banking system. 

On the fiscal front, health services will obviously need the resources to ensure that they can function properly and governments are making the right noises to ensure that this will be forthcoming. Another issue which has come to light in recent days is to ensure that there is an adequate form of employee insurance in place. One of the problems for workers, particularly at the low end of the income scale, is that they do not get paid if they do not turn up for work. But if infected people turn up for work in order to collect their pay cheque they run the risk of infecting others. The last thing that hospitals need is for infected porters or cleaning staff to be running around the place. In the UK, those who are self-employed, who account for 15% of total employment, are not entitled to sick pay. Some form of temporary scheme to compensate them for loss of earnings is certainly an option worth considering, even though the practicalities of such a scheme are quite daunting.

But when all is said and done, the best thing the authorities can do to minimise the economic impacts of COVID-19 is to ensure that infection rates are held down. So far as China is concerned, there are hopeful signs that things are improving. The rate at which infections are increasing has not exceeded 2% for the past 9 days as the draconian measures put in place start to take effect. Outside of Hubei Province, the epicentre of the outbreak, there are only 13,000 confirmed cases and just 112 deaths – less than in the rest of the world (166). Prevention is always better than cure but preparedness runs it a close second.

Reflections on a market rout

Many people have remarked about the end of days feel in the markets. Here in the UK, many regions of the country have experienced unprecedented flooding, with more to come over the weekend, whilst parts of Africa and Asia are enduring a plague of locusts. This is before we even talk of the coronavirus which has gripped the imagination like no epidemic in recent history. 

I did point out at the start of the year that short of an exogenous shock it was difficult to know what would derail the equity market. Such shocks are by their nature difficult to foresee but who would have thought that the catalyst for change in market thinking would have come in the form of something we cannot see but whose presence we are aware of – a veritable ghost at the feast? Equities have just posted their biggest weekly correction since 2008, and having experienced similar corrections in the past, I know the futility of trying to call the market bottom. The extent of market concern can be gauged from the VIX index of implied equity market volatility which has shot up to a level of almost 48 (recall that three weeks ago I expressed astonishment that it was running so low), taking it to its highest level since 2011 (chart below).

Whatever the longer-term health implications, there is clearly going to be a period of intense economic disruption. It could last for days, weeks or even months, but it is clearly going to impact on activity rates at the end of February and into March. Such is the power of the unknown triggered by the virus that face-to-face client meetings are being cancelled as businesses test their disaster recovery procedures; Switzerland has banned gatherings of more than 1000 people, with the result that two major trade fairs including the Geneva Motor Show have been cancelled, and travel restrictions are being ramped up. Naturally this will adversely affect corporate earnings, which explains the collapse in markets over the past week (I would not like to be in the insurance business at the present time). This raised a question in my mind regarding the information content of the equity market collapse for events in the wider economy. After all, investors focus on the slope of the 2-10 curve in the bond market, but is there a corresponding equity indicator?

The information content of market corrections for the real economy

In order to assess the severity of the market collapse we need an indicator which measures both the extent and duration of the collapse. In order to do this, I looked at all trading days since 1940 and calculated those periods when the S&P500 declined for five consecutive sessions, and measured the resulting 5-day change in the index (I excluded the period 1928 to 1939 due to the volatility of the index over this horizon). I reduced the sample still further to select the subset of periods where the fall in the index cumulated to more than 7% (admittedly an arbitrary value). This resulted in 15 episodes (not counting the current one). To put some values on it, I measured the sum of peak-to-trough declines across all such episodes per calendar quarter. For the most part these are zero but in 13 cases there was one such event per quarter and in 1974 and 2009 there were two, resulting in index values of between -15 and -20 (chart below).  

As a leading indicator, the index is by no means perfect. It has provided three false recession signals (1962, 1986 and 2015) and did not foresee the recessions of 1969-70 and 1980. But it did provide useful information in 1974, 2000 and 2008. In this sense it is not that much different from the 2-10 curve which often flashes false recession signals. And it may be possible to improve it by being more systematic about measuring the decline threshold.

It would thus be too much of a stretch to suggest that the equity market is pointing to a recession in the US, but given the expected impact on activity as a result of what has been going elsewhere in the world, some slowdown in growth is likely. Moreover, given the duration of the US business cycle, which is the longest in recorded history, it may also be vulnerable to shocks. One transmission mechanism from the market is the consumer wealth effect. Estimates of this effect vary but a study produced by the IMF in 2008 suggested that the long-run elasticity of US real consumption with respect to equities is around 3.5%. In other words, each one dollar decline in the value of equity holdings will reduce consumption by 3.5 cents. If the market holds at current levels (13% down), this would imply a reduction of around 0.4% in consumption. If this spills over into other assets, such as housing, the impact will be even bigger since the US housing wealth elasticity of demand was estimated at 13.7%.

Is there value out there?

We are, of course, getting ahead of ourselves. Anecdotal evidence suggests that real money investors have not sold off to anything like the extent to which the headline index suggests. If true, it might indicate that the selloff has been exacerbated by algorithmic trading. An academic study published in 2017[1] suggested that the rise of exchange traded funds (ETFs), which are essentially passive investment funds which track the market, means that investors derive “lower benefits from information acquisition”, thus reducing their incentive to undertake it. This in turn reduces the efficiency with which investment decisions are taken and raises the risk that market swings may be larger than would otherwise happen in the event of a market where investors are forced to do their own due diligence. Once the dust settles, regulators will undoubtedly take a closer look at this issue given their mounting concerns over the impact of black-box trading models on market swings.

For now, however, investors are flying blind. Whether the coronavirus effect turns out to be a flash in the pan or a prolonged problem, the time for taking risks is over. As winter slowly gives way to spring, the next few weeks are going to be interesting. There is no doubt that the recent shakeout has taken a lot of air out of the balloon and on the basis of Robert Shiller’s long-run CAPE measure, we are now starting to approach less toppy valuation levels (chart below). This long-run P/E measure is now close to 27x versus 31x before the rout started. But if this is a trigger for a cyclical correction as in 2000-01, there could be another 10-20% market downside as the CAPE heads towards 23x. 

Brave investors will likely step in at some point soon. As Warren Buffett, the grand old man of value investing, once said, “Widespread fear is your friend as an investor because it serves up bargain purchases.” But Buffett also knows the value of waiting until the price is right.

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[1] Israeli, D., C. Lee and S. Sridharan (2017) ‘Is There a Dark Side to Exchange Traded Funds? An Information Perspective’ Review of Accounting Studies (22), pp 1048-1083

Going viral

I noted a few weeks ago that the coronavirus, now known as COVID-19, was likely to make its presence felt in the markets sooner or later and yesterday was the day when the dam broke. The S&P500 fell by 3.4% compared to Friday whilst the Italian stock exchange index was down 5.4% as cases of the virus were reported in the north of the country. Trends in the Chinese market may give us some indication as to how things might pan out. The Shanghai Composite index fell 11.8% in the space of 9 trading sessions although it has since rebounded to leave it just 3.3% below the mid-January peak. This recovery has occurred despite the fact that the economy was in lockdown for a week and even now activity is only slowly recovering. However, whilst the World Health Organisation has so far not officially labelled the current outbreak as a pandemic, as more cases are reported throughout the world it seems only a matter of time.

Whilst various numbers have been bandied around, with some estimates suggesting that the virus outbreak could shave USD 1 trillion off world output, the truth is that nobody really knows, and efforts to estimate it give a sense of false precision. But we can trace out the broad mechanism by which pandemics operate. In the first instance, there is a hit to the supply side of the economy as people fall ill. Depending on the fatality rate this can either be a short-term or long-term effect. In the case where the fatality rate is low and people subsequently recover, there is a short-term reduction in the economy’s productive capacity. When the fatality rate is high, the effect is likely to be more permanent. There is also a demand side effect as people avoid contact with others, and as a result they shop less and consume fewer services (e.g. they stop going to restaurants) as they enter a period of self-quarantine.

Historical estimates of the impacts of past pandemics are often quite hazy but the Black Death which struck Europe in the 14th century wiped out anywhere between 30% and 60% of the continent’s population. GDP in England alone is estimated to have declined by over 50% in the century following the plague whilst population fell by 60% (chart below). In fact, it took 200 years for output to reach pre-plague levels and 275 years for population to recover. The good news is that (so far) COVID-19 is far less virulent than the plague which was responsible for the Black Death. Perhaps the best comparison in terms of virulence is the Spanish flu outbreak of 1918, which had a fatality rate of 2-3%. It infected an awful lot of people (around 27% of the global population at the time) but its spread was facilitated by the movement of people as World War I entered its final stages. Scientific experts differ as to why the mortality rate was so high: Some suggest that the pathogen itself was particularly nasty whereas others suggest that it was no more virulent than other strains of flu but that malnourishment and crowded medical facilities promoted superinfections that proved to be the real problem.

I don’t want to dwell on the negative aspects but suffice to say that COVID-19 is a serious disease which has the potential to inflict a big hit on the world economy. However, the risks and consequences are not evenly distributed. Some sectors, such as pharmaceuticals, may actually benefit in the short-term if they are involved in the search for vaccines, antibiotics, or other products needed for outbreak response. On the other hand, vulnerable populations in poor countries with reduced access to medical care would be expected to suffer more than proportionally if things got out of hand.

As Bloom, Cadarette and Sevilla noted in a 2018 paper published by the IMF, “several factors complicate the management of epidemic risk” notably climate change, globalisation and urbanisation but “perhaps the greatest challenge is the formidable array of possible causes of epidemics, including pathogens that are currently unknown” (as was the case with COVID-19 just a few weeks ago). However, there is still a lot that governments can do to limit the fallout once the epidemic takes hold including surveillance measures, collaboration and measures to curb the spread of disease by limiting movement (as the Chinese were quick to do).

Aside from the economic aspects, it is the natural fear of the unknown that has caused markets to take fright. If investors are rational, they should not be selling now. As Warren Buffett said in a TV interview, “the real question is: ‘Has the 10-year or 20-year outlook for American businesses changed in the last 24 or 48 hours?” There again Buffett is 89 years old and mortality statistics suggest there is a 14.87% chance that he will depart from this life in the next year (sorry Mr B. Blame the actuaries!). But if you are a 35-year old investor, you might have a different outlook on things and fear of the unknown is a powerful influence on behaviour. However, to put a positive spin on things, as the number of Chinese cases continues to rise – albeit at a slower pace – so does the number of recoveries, with 35% of those diagnosed now having been cleared, and they outnumber deaths by a factor of 18:1.

As Bloom et al wrote, “We cannot predict which pathogen will spur the next major epidemic … But as long as humans and infectious pathogens coexist, outbreaks and epidemics are certain to occur and to impose significant costs.” The best we can do is to take actions to manage the risk and mitigate their impact, although as the deadly outbreak of Ebola in West Africa in 2014 showed, it is possible to limit the consequences relatively quickly. Let’s hope so.

Priti vacant

The Home Secretary, Priti Patel, sits on the right-wing of the Conservative Party and can best be described as socially illiberal (see this clip from one of the BBC’s flagship current affairs programmes in 2011 in which she quite clearly advocated the return of the death penalty). She also backed Theresa May’s hostile environment immigration policies, presented in the immigration bills of 2014 and 2016. But Patel is nothing if not entrepreneurial although her efforts to go off-piste by holding unauthorised meetings with Israeli politicians and businesspeople in 2017 did result in her being sacked from May’s government. Nonetheless, her voting record marks her out as an economic liberal, generally voting against policies such as higher taxes.

This week’s announcement by Patel that British businesses will effectively be barred from hiring “unskilled” workers from outside the UK after the Brexit transition process ends, is both socially and economically illiberal. The policy, which is outlined here, will bring in a points-based system “that will attract the high-skilled workers we need to contribute to our economy” whilst keeping out those the government presumably deems undesirable. Undoubtedly there is a preference amongst some voters for this kind of policy, as this clip reporting the views of a BBC Question Time audience member makes clear (the fact that it is both offensive and inaccurate is beside the point – this is what some people believe). However, the policy suffers from a number of theoretical and practical limitations that potentially threaten to introduce yet more economic disruption.

Starting with the macroeconomic implications, the fact that business investment has been so weak over recent years underlines the importance of labour input in driving growth. In Q4 2019, business fixed investment volumes were only 1.3% higher than mid-2016 levels – an annual increase of less than 0.4% per year. To put that into context, the average annual growth rate over the period 1966 to 2015 was 2.9% – and even that is widely considered to be too low in comparison to other European economies.

My calculations suggest that since 2015, the contribution of capital to potential GDP growth (currently estimated at around 1.5% per year) has fallen by 0.2 percentage points to 0.5 pp per annum largely due to a lack of investment which has resulted in a less efficient capital stock. Total factor productivity, which accounts for factors such as technical progress and other intangibles, has recorded a dreadful performance since 2008 and is currently not giving any boost to potential growth (chart). Thus the labour contribution accounts for a good one percentage point per annum. This can be broken down into the increase in the overall working population (0.2 pp); participation (0.2 pp); the employment rate (0.4 pp, defined as the extent to which available labour resources are being used) and hours worked (0.4 pp).

Other things being equal, measures that disrupt labour supply will act to curb the economy’s growth rate. As it is, the population is ageing and the retirement of the baby-boomers means that the working age population is growing at a slower rate than in the past. Moreover, the big boost derived in recent years from an increase in hours worked and the employment rate (number of employees relative to the total working age population) appears to be losing momentum (cf chart). Patel’s response to this problem was to suggest that any shortfalls can be met from the 8.5 million people currently classified as “economically inactive” which effectively means raising the employment rate. But of that figure, 2.3 million are classified as students; 1.9 million are looking after their family and 2.1 million are registered as long-term sick. Only 1.9 million are classified as looking for a job. This implies that the employment rate can only rise from current levels of 79.5% to a theoretical maximum of 81% – the 1.5 percentage point rise represents the amount by which it has increased over the past four years. There is a lot less slack in the labour market than the Home Secretary seems to think. 

As for a points-based system (PBS), the report from the government’s non-partisan Migration Advisory Committee (MAC) released last month was less than enthusiastic. The Committee chairman’s comments indicated that whilst he understood the government’s need to communicate complex issues to the electorate, PBS currently only represents a “soundbite” with no coherent plan as to how it would work (surprisingly enough, his contract as chairman of the MAC was not renewed). The biggest criticisms include the inconvenient fact that countries which do rely on a PBS, such as Canada and New Zealand, only use them in parts of their immigration system – it is not the bedrock. Moreover, when the UK experimented with such a system to recruit non-EU workers between 2002 and 2006, it did not attract the highly-skilled workers which the government hoped for. And as the MAC report notes, the current system to attract highly skilled workers from outside the EU “does not work well … [because] the skills bar for entry is set far too high, targeted at those at the very top of their field and is too risk averse.”

The government has accepted one of the MAC’s recommendations, to reduce the annual salary threshold from £30,000 to £25,600. Workers who do not meet the points requirement to qualify for entry must therefore meet this salary threshold – the idea being to dissuade “lower-skilled” workers from entering the UK (though as the government points out “under the points-based system for skilled workers, applicants will be able to ‘trade’ characteristics such as their specific job offer and qualifications against a lower salary”).  As if the other aspects were not contentious enough, this element threatens to open up a new can of worms. Many jobs in the health and social care area are not low-skilled at all, yet do not offer a salary which meets this threshold. A phlebotomist, for example, will struggle to earn £20,000. Full-time social care workers, of which around 20% are foreign nationals, earn around £19,500 per year – 24% below the recommended limit.

The government plans to introduce these new rules once the transition period with the EU expires at the end of this year. Not only is that not a lot of time to adjust but as Tom Hadley, director of policy at the Recruitment and Employment Confederation, said: “Jobs the government considers ‘low-skilled’ are vital to wellbeing and business growth. The announcement threatens to shut out the people we need to provide services the public rely on. We need access to workers that can help us look after the elderly, build homes and keep the economy strong.” What the policies amount to is an upgrade of the state-sponsored hostile environment which the Conservatives have pioneered over the past decade. Such an unwelcoming environment runs the risk that the UK is no longer the first port of call for talent in a world where other countries are desperate to import skills which are in short supply at home. If the government does go ahead with its introduction, my guess is that within a couple of years it will be forced to water down the restrictions.

And for all the contradictions inherent in the new rules, the biggest of them all is that Patel’s parents, who migrated to the UK from Uganda in the 1960s, would not have qualified for entry under the rules their daughter has drawn up. You could not make it up. Except that the government is indeed making it up as it goes along and runs the risk of strangling itself in a knot of contradictions.