A Rude Awakening for Investors
15 Pages Posted: 27 Mar 2020
Date Written: March 1, 2020
Surging market sentiment faltered in mid-January with the worsening news on the new coronavirus (Covid-19) outbreak in China. The upswing in investor risk appetite sparked last October by easing trade tensions had gathered further momentum during the first half of the three-month period under review.1 Starting in mid-January, however, concerns over the economic impact of the new epidemic in China dented investor confidence. The intensity of the ensuing risk-off episode, which had an uneven impact across asset classes and regions, fluctuated in response to news detailing the spread of the coronavirus across the globe. As of late February, jittery markets and abundant signs of investor caution indicated that the risk-off phase was not yet over.
The announcement on 13 December of a formal signing date for the phase-one trade deal between the United States and China breathed new life into a fading stock market rally. In early January, global equity valuations reached new highs amid incoming data suggesting that manufacturing activity was likely to have bottomed out at year-end. Among emerging market economies (EMEs), the stock markets of the countries more closely integrated in global value chains (GVCs) appeared to have benefited relatively more. The buoyant sentiment steepened yield curves and compressed corporate credit spreads in advanced economies (AEs), as well as sovereign and corporate spreads in EMEs. With a risk-on phase in full swing, stock market-implied volatilities fell back to recent lows. Consistent with the rise in risk appetite, the US dollar depreciated notably over this period.
First in mid-January, and then with even greater intensity in late February, the worsening news relating to the Covid-19 outbreak roiled markets. As investors fretted over the outbreak's economic fallout, commodity prices dropped, longer-term yields in AEs declined appreciably, and the mid-range of the US term structure inverted. Stock markets across the globe swung with news of the virus outbreak, relinquishing their earlier gains by late February. The US dollar appreciated, in particular against currencies of emerging Asian economies and commodity exporters. Although credit spreads widened somewhat, credit markets in AEs and fixed income markets in EMEs remained resilient, with portfolio inflows into EMEs continuing into February. All told, a stronger US dollar, depressed commodity prices, heightened stock market-implied volatilities and a deep inversion of the US term structure signalled a significantly more cautious mood by late February - the end of the review period.
Throughout, the central banks of major economies maintained an accommodative policy stance, while those of some large EMEs eased policy further. Overall, investors expected policy rates to stay unchanged in the short to medium run. That said, futures markets priced in some further easing by the Federal Reserve in the second half of this year.
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