Rising risk of a Global Financial Crisis-type market correction

Global equities have fallen sharply and at a rapid pace since they peaked in mid-February, as coronavirus cases continue to rise outside of China. It took just 19 days for the US S&P 500 index to enter an equity bear market (defined as a drawdown of more than 20%), the fastest on record from data going back over 100 years.

Given the extent of the market moves from the coronavirus in 2020, comparisons will made to equities’ last bear market during the Global Financial Crisis (GFC) in 2008. So far during the coronavirus crisis, the MSCI All Country World Index in US$ terms is down 22% from its high in mid-February, compared to a 59% peak-to-trough fall during the GFC.

There are key differences between these sell-offs. During the GFC, investors were worried about banking sector counterparty risk leading to systemic risk in the financial system. In contrast, the coronavirus is the catalyst that has encouraged investors to reduce risk simultaneously in their portfolios after years where ultra-low interest rates encouraged traditional long-term investors like pension, mutual and insurance funds to take on more risk than they would have normally done in order to seek returns. Clearing prices have also been impaired somewhat by tighter regulations introduced since the GFC that reduced the number of market makers providing liquidity. Along with algorithmic trading and an unwind in passive investing, this has led to more market volatility and extreme price swings.

Looking forward, on top of the supply-side shock coming from China and locking down parts or whole countries (e.g. Italy and Spain) in advanced economies, this will inevitably lead to lower demand growth too and raises the risk of a global recession. Business short-term cash flow needs are likely to become stretched, adding to stress in credit markets and the financial system in general. In its second emergency meeting in the last fortnight, the Fed cut interest rates to zero and restarted its quantitative easing programme to buy Treasury and mortgage-backed securities. However, the Fed failed to bolster liquidity in the US commercial paper (CP) market, which is used by companies for short-term loans to cover the business running costs like payrolls. During the GFC the Fed provided a CP funding facility, where the central bank purchased CP directly from issuers and dealers directly.

If the Fed fails to backstop the CP market, companies may be forced to run down cash assets that could precipitate money market outflows and spread contagion through the financial system. Markets are selling off this morning to discount this risk. Given this backdrop, there is potentially more room for equity downside until coronavirus cases peak.

*Source: Refinitiv Datastream, data as at 16th March 2020

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