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Why investors should brace for aftershocks

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Via Financial Times

Financial markets are enjoying a recovery after Monday’s shock. The bounce is natural, given the severity of yesterday’s 7 per cent crash in global equities. But investors tempted to buy the dip should be mindful that sell-offs of that magnitude tend to ripple far and wide.

Saudi Arabia’s decision to start an oil price war triggered the biggest one-day slump in crude prices in almost three decades, and heightened the anxiety of investors whose nerves were already frayed by the spreading coronavirus.

The result was a day of mayhem on markets, best exemplified by Wall Street’s “fear gauge”, the Vix, surging to its highest level since the peak of the financial crisis in 2008. The FTSE All-World stock index has now tumbled 17 per cent from its February peak

That sense of total capitulation, mixed with expectations of twin fiscal and monetary policy stimulus, has naturally led some investors to think that now is the time for bargain-hunting. European equities are about 3 per cent higher on Tuesday, and US futures indicate that the S&P 500 will open up at a similar gain.

Buying the dip does make some sense. In time, lower oil prices should prove an economic boon, and China, the epicentre of the coronavirus outbreak, does indeed look like it has slowed the virus’s spread.

“This is not 2008,” BlackRock, the world’s biggest asset manager, argued in a report sent out on Monday evening. “The economy is on more solid footing and, importantly, the financial system is much more robust today than going into the crisis of 2008. We don’t see this as an expansion-ending event — provided that a pre-emptive and co-ordinated policy response is delivered.”

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Nonetheless, investors have a multitude of reasons to remain wary, which means Tuesday’s bounce could prove brief. While it is perfectly true that the financial system is far more resilient than it was during the financial crisis, market earthquakes of this magnitude tend to cause aftershocks.

Investors have been pulling money out of riskier funds for a few weeks, but flows often lag returns. The severity of the recent slump means that even if markets continue a cautious recovery this week, many asset managers have to gird themselves for some hefty outflows in the coming days and weeks. That will probably reveal some further faultlines that were previously hidden by buoyant markets.

Awaiting a co-ordinated, aggressive policy response also looks hopeful. The Federal Reserve has already cut interest rates by half a percentage point, leaving it with just another percentage point before it hits zero — which it has indicated it considers its lowest possible level. The European Central Bank and the Bank of Japan already have negative interest rates and vast bond-buying programmes, and it is questionable what more they can do that would soften the coronavirus blow and reinvigorate economic growth.

Fiscal policy, in terms of targeted government spending designed both to fight the pandemic and boost flagging demand, might do the trick. But given some countries’ sizeable budget deficits, high debt levels and the political resistance in some quarters to fiscal stimulus, it seems Pollyanna-ish to think we will now see something that does more than soften the blow.

While the oil price crash may be stimulative in time, the more immediate concern is the damage it might inflict on credit markets. Companies have been on a borrowing binge in the past decade, and yield-hungry investors have been willing to oblige. But the inevitable surge in energy company downgrades and defaults will echo through the corporate bond market. It is notable that the 2014-15 oil slump did little to invigorate economic growth, with the negative impact swamping the positives.

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We have moved from an environment where a global recession was hard to envisage, to one where it was possible, and now to one where it may be hard to avoid. We are not out of the woods yet.

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