At some point the music stops playing for investors. Yesterday’s steep drop in the oil price sent traders across equities, credit and emerging markets rushing for the pause button.
The initial shock was the coronavirus outbreak’s impact on the global economy. Then came the blow of an oil price war. Next is escalating financial contagion. Markets are likely to burn until the fuel of high debt levels and aggressive risk taking is extinguished.
Investors are seeking at least some protection in “long bonds” as their portfolios suffer a hit across equities. Many portfolios were already nursing losses from big falls over the past two weeks. And while an oil price war raises the pressure on energy shares and debt, it also reinforces demand for the safety of long-dated government bonds. The fall in the US’s 30-year Treasury yield — from 1.7 to just 0.7 per cent in the past three trading days — suggests investors do not believe central banks can prevent the world from sinking into deflation.
Big market shake-outs can escalate over weeks as risk managers subject portfolios and trading desks to tighter limits. There is also the prospect of increased margin calls on traders to raise collateral on their positions. In turn, that is likely to compel the sale of shares that have performed strongly until now. A more troubling sign for markets would be asset managers “gating” their funds, or preventing investors from selling their holdings.
Many seasoned investors will note that markets ultimately bounce back from bouts of turmoil. Buying the dip has worked no matter how tough times have looked. The scale of yesterday’s equity declines is a necessary development before markets eventually stabilise and recover. One small consolation is that the combination of
ultra-low interest rates and oil prices — along with governments boosting their spending — should start to lift the global economy in the next few months.
“The catalysts for a market turn are more likely to be some combination of peak infection rates, underweight positioning and very cheap markets,” says JPMorgan’s John Normand.
On those metrics, financial markets face quite a wait before the music starts playing again.