Fears increase that deadly virus could hit global growth and prompt a surge in volatility
Peter Wells in New York
A member of medical staff wears protective clothing at a hospital in Wuhan, China, as coronavirus fears grow © Hector Retamal/AFP/Getty
In February 2018, markets were struck by an outbreak of volatility that tore Wall Street down from record highs, prompting some to dub it a “virus.” Nearly two years later, and with US stocks again near a peak, investors are wondering whether an actual virus might bring back some more drama to markets.
Optimists may point to the relative resilience of the market’s “fear gauge”, the CBOE Volatility index — or the Vix — which reflects the cost of buying short-term options on the S&P 500. This year the index brushed off heightened tensions between the US and Iran. But the adverse effects of a global pandemic could have a bigger impact on one of the things that still manages to unsettle volatility indices — expectations of economic growth.
The swift de-escalation between Washington and Tehran allayed concerns about impacts on the global economy, through higher oil prices. That helped the Vix revert to a near-two-month low of 12 — well below its 10-year average of 17 — and set the stage for a series of record highs for US stocks in subsequent sessions.
That flare-up in the Middle East also failed to disturb a three-month run in which the closing price of the S&P 500 has moved less than 1 per cent in either direction. That is one of the longest such streaks of the past half-century.
Nor has the tranquillity been confined to equities. On Monday, the JPMorgan Global FX Volatility index hit a record low, while Bank of America’s index of Treasury volatility last week reached its lowest point in eight months. Investment-grade credit default swap spreads, meanwhile, which reflect perceived risks of higher-quality companies failing to pay their interest bills, narrowed to their tightest in years.
“If growth were to contract more substantially for some reason, whether because it’s fiscal policy not working or global tensions aren’t a chess game back and forth, I think you’ll have bigger moves,” said Kathryn Kaminski, chief research strategist at AlphaSimplex Group. “That’s what is driving everything.”
The coronavirus outbreak in China might just cause that contraction. The virus has spread to a number of Asian countries and resulted in one confirmed case on US soil. Analysts are already reflecting on the impact that the 2003 Sars epidemic had on economies in Asia, particularly in consumer spending.
Economists at Goldman Sachs say that negative impacts on growth and asset prices from viral outbreaks typically fade within a few months. But any hit to the economy is unlikely to be well received by investors at a time when they are positioned for growth to accelerate.
Equity fund flows, which tend to be closely tied to global growth, have ratcheted up strongly since the end of October. Investors have poured a combined $66bn into equity ETFs and mutual funds over the period, reversing outflows over the previous 10 months, according to Deutsche Bank.
Investors spent a good portion of 2019 worrying about the growth outlook, and particularly over the summer, when volatility touched some of its highest points for the year.
The market has since stepped back from the precipice. But analysts say there is a clash between the new-found optimism and the economic data, which are not exactly strong. “People are exposed to equities much more than is the historical norm and at a point when growth hasn’t really picked up yet,” said Parag Thatte, strategist at Deutsche Bank.
Another factor in the market’s muted reaction to recent geopolitical risks is the actions of central bankers. Their continued support through low interest rates and asset-purchasing programmes is seen as a primary reason why volatility has been crushed.
That is why hedge funds continue to bet the stock market will remain calm, according to net short positions on the Vix tracked by the Commodity Futures Trading Commission.
In late 2017, such net short positions reached a record, and a couple of months later a bout of turmoil linked to the implosion of several Vix-linked funds triggered a rapid correction. Two months ago, net shorts on the Vix again hit a fresh record as hedge funds bet big against volatility returning — though positions have been trimmed since mid-November.
The problem with such complacent positioning is that when something does upset the market, the chance of a heavy sell-off is heightened. At a time when investors have not seen any significant daily swings since mid-October, when the US agreed a limited trade deal with China, anything really piercing the calm could prove a rude shock.
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