Why coronavirus could cause a 1990s-style bubble in risk assets

Threat of slump in global economy

Lauren Mason
Anatole Kaletsky at IW's Funds To Watch event

Anatole Kaletsky at IW's Funds To Watch event

The coronavirus outbreak will significantly impact risk assets over the coming "years, rather than months", according to economist and author Anatole Kaletsky, who warned that central bank reactions to the illness could artificially inflate asset prices and lead to a "greater-than-expected boom and bust" across global stockmarkets.

Speaking at Investment Week's Funds to Watch conference at The May Fair Hotel last week, Kaletsky suggested a sudden and drastic collapse in asset prices could spark an economic downturn, which would lead to an economic period more similar to the 1990s tech boom and bust, as opposed to the 2008 Global Financial Crisis.

"At the start of the year, it looked as though the world economy was beginning to fire on all cylinders, and what would end the cycle - if anything - would be a relatively conventional boom-bust in asset markets," he said.

"Then the coronavirus came along and everything has suddenly gone in the wrong direction.

"If this bull market ends - and maybe it is ending right now - and if the global expansion ends, then there will be the slump in the world economy caused by absent supply chains and low productivity.

"While this would impact the world economy, financial markets and risk assets over the next quarter and maybe the first half of this year, this could have ramifications two to three years ahead, making it more likely that the cycle will end with a much bigger asset price bubble than we are seeing today as opposed to slowing down into a period of secular stagnation, which is what we might have expected."

Pause in boom/bust

Kaletsky said the coronavirus could lead to two outcomes for investors - that the "boom phase" we have been in over the past decade will be capped, or that the boom/bust cycle will be postponed rather than eliminated which, he warned, would lead to a "much more extreme" asset price appreciation further down the line.

"It seems much more likely we are going to have a policy overreaction from both the US and China, where they do whatever it takes to ensure the second half of this year sees a v-shaped recovery," he reasoned.

"If we get a very strong policy response combined with what could be a mild effect on the health of the world's population, by the second half of this year, then I think we have the makings of 1999."

Kaletsky pointed out that in 1997 the US Federal Reserve began gradually tightening monetary policy after a prolonged period of rude economic health.

Then, following the sudden devaluation of Russian debt and subsequent defaults, the Long-Term Capital Management hedge fund - which at the time was the largest hedge fund in the world managed by two Nobel Prize winners - folded, spooking markets and the Fed into thinking the global economy was on the brink of collapse. The Fed therefore began cutting rates again, unnerving investors further and leading to a 40% fall in the NASDAQ index.

"By the time the Fed cut a third time though, the NASDAQ took off into the stratosphere because the economy had not collapsed, and it looked as though the policymakers were willing to do whatever it takes to prevent the crisis that people were worrying about," Kaletsky explained.

Scenario analysis carried out by MSCI, assuming short-term growth falls by two percentage points and the equity risk premium increases by the same amount, suggested the US equity market risked a decline of 22% in the near term, while global stocks could fall by 20%.

Eyes on China

Kaletsky pointed out that, in the current environment, all eyes will be on China's monetary policy given it is the most severely affected region and the world's second-largest economy.

Because so many people are in isolation, he reasoned Chinese policymakers can do very little to stimulate the economy and that if the virus becomes a long-term epidemic "the world would become stuck", having a "devastating effect on businesses all over the globe".

"Yet if China is stuck for the quarter or so, maybe logging a 10% GDP decline for the first half of the year, but the coronavirus comes under control, the supply side of the Chinese economy could stabilise to the point where they can flush enormous amounts of fiscal stimulus into it in order to create this v-shaped recovery," the economist explained.

"Then, by this time next year, China and probably the world economy - if the Fed were to follow suite, which it most likely would - will be back onto the same kind of growth trend as we saw before the coronavirus and that is where we get those bubble-like conditions from."

Jon Jonsson, senior fixed income portfolio manager at Neuberger Berman, agreed with Kaletsky that the virus could "give political cover" for the fiscal stimulus the economy needs to extend the cycle "well into 2021".

"There may be too much policy easing priced into rates and bond markets, but not enough economic disruption priced into high yield and equity markets - more volatility is likely before the recovery arrives," he warned.

Muted activity

Eoin Murray, head of investment, international at Federated Hermes, said it is "distinctly possible" that economic activity will remain muted throughout the rest of 2020.

"As the Fed's 50 basis-point cut has shown, interest rates will neither cure the virus nor repair the supply chain damage," he said.

"In extremis, one could heed the words of Bill Gates: 'In the past week, Covid-19 has started behaving a lot like the once-in-a-century pathogen we have been worried about. I hope it is not that bad, but we should assume it will be until we know otherwise'."

Luca Paolini, chief strategist at Pictet Asset Management, agrees. He said the firm's portfolios have shifted to a "more defensive footing, taking equity allocation into underweight", in the event the coronavirus becomes a pandemic.

"Academic research suggests that a mild pandemic, like the Hong Kong flu of 1968-1969, would trim global economic growth by 0.7 percentage points.

"A severe one, modelled on the Spanish flu half a century earlier, would slash it by 4.8 percentage points, tipping the world into recession," he warned. "Crucially, the impact will be widespread."

Cause for optimism?

Not everybody is nervous, however. Ryan Hughes, head of active portfolios at AJ Bell, pointed out that "no one knows exactly how this will play out" so it will be a case of remaining vigilant and acting appropriately.

"Investors should not panic, we have been through periods of market volatility before and will do so again."

Gary Moglione, fund manager at Seneca Investment Managers, added: "The investment horizon is what is important. The short term horizon is extremely delicate due to the unpredictability of this epidemic.

"However, we are happy to hold the stocks we are buying for the long term."