The Markets Were Already Vulnerable, Then Came Coronavirus

Kevin Kelly, a CoinDesk columnist, is a co-founder and chief market strategist for Delphi Digital, a research and consulting boutique dedicated to the digital asset market.

The “Everything Rally” that has characterized financial markets for much of the last year was flipped on its head this past week as the markets scrambled to make sense of the growing uncertainty surrounding the coronavirus outbreak. The extent of last week’s price falls took many by surprise, but underneath the surface the risk of a major correction had been building for weeks as bond and equity markets began pricing in faltering outlooks for the global economy. On Feb. 19, the day the U.S. equity market peaked, I noted a handful of key indicators that highlighted this polarity, and it appears the “inflection point” for markets has finally arrived.

Up until last week, markets were sending opposing messages as to how the future was likely to unfold. On one hand, stocks appeared entirely unfazed by the latest COVID-19 developments; so much so that on Feb. 19, the S&P 500 notched its 25th all-time closing high in the last 60 trading days. Meanwhile, the “safest” corners of the bond market (i.e. U.S. Treasurys) were trading like the worst was yet to come as yields on 10-year Treasury notes fell to within 20 basis points of their all-time low. Fast forward and we’ve finally seen risk assets cave to the bond market’s view coming off the S&P 500’s worst weekly decline since the 2008 financial crisis.

It’s still too early to tell whether the coronavirus will be the proverbial straw to break the back of the longest economic expansion in U.S. history, but the outbreak certainly threatens to destabilize an already vulnerable global economy, the implications of which will be felt across every asset class, including those in the digital asset space.

Let me preface this by saying I’m no epidemiologist (nor do I play one on TV) and there are still a great deal of unknowns surrounding COVID-19. Even the reported case totals (which breached 90,000 over the weekend) are to be taken with a grain of salt given inconsistent testing and politically motivated repression. It’s difficult to forecast the economic fallout because a global pandemic hits aggregate supply and demand simultaneously. Attempting to forecast the impact of coronavirus on global GDP at this juncture is like trying to hit a moving target while strapped inside NASA’s MAT simulator. Nevertheless, I believe there are two scenarios that present the most likely path forward.

The optimistic scenario and the pessimistic one

Behind door number one is the optimistic scenario: The repercussions of the coronavirus outbreak are relatively short-lived, the demand curve shifts out a few quarters, and an antiviral vaccine is tested and approved to help contain its contagion. Such circumstances would all but guarantee a serious correction in bonds, notably U.S. Treasurys, which are pricing in aggressive rate cuts by the Federal Reserve in the coming weeks. The assumption global interest rates can only go lower has become ingrained in market consensus, increasing the downside asymmetric risk to the safety trade that’s pushed long-dated Treasury yields to their lowest level on record. Conversely, risk assets, such as stocks, would also rebound, likely breaking back to all-time highs. While many people find this scenario highly unlikely, it’s important to note how strong market consensus is for a far more dire outcome. Let’s hope for everyone’s sake the market is wrong.

Creeping behind door number two is the doomsday scenario: Coronavirus contagion fails to be contained, major metropolitan areas come under quarantine, fear and panic spreads like wildfire, and the global economy comes to a grinding halt. This would undoubtedly prompt central banks to cut rates aggressively (as the Federal Reserve has already proven) and restart their infamous asset purchase programs (if they haven’t already). This may provide temporary relief to markets, but it’s less likely to stave off a powerful deflationary threat to global demand, unless these cuts keep credit conditions relatively loose.

Policymakers would also ramp up fiscal stimulus measures in an attempt to support their central bank counterparts, specifically targeting small and medium-size businesses facing temporary cash flow disruptions. Rampant Treasury issuance would likely be soaked up by the Fed, pushing its balance sheet, national debt and the risk of dollar debasement to new heights.

At the same time, public fear over COVID-19 coupled with the growing number of mandated quarantines, travel restrictions and company shutdowns pose a considerable threat to global consumption, notably the U.S. consumer. American consumption is not only the backbone of the U.S. economy, it serves as a major support for global economic activity, too. This is where the situation can get dicey quickly.

Historically low rates encouraged an explosion of non-financial corporate debt issuance over the last decade, which recently surpassed $10 trillion in the U.S. alone (and that’s not even counting a swath of small and medium-size private businesses). Not all debt is inherently evil. When the economy is expanding, companies can take on leverage to grow their operations and increase market share. In theory, these companies become more profitable and thus are more capable of servicing their debts. But the world is far from ideal, and debt loads have continued to grow even as the outlook for corporate profitability weakens, not to mention Wall Street’s obsession with share buyback plans. On top of that, "BBB"-rated bonds (one rating above speculative-grade) now make up over 50 percent of investment-grade debt in the U.S., according to S&P Global.

Attempting to forecast the impact of coronavirus on global GDP at this juncture is like trying to hit a moving target while strapped inside NASA’s MAT simulator.

If the fallout from coronavirus weakens consumer spending and aggregate demand takes a hit, companies big and small will see a slowdown (or contraction) in sales. Falling revenue would pressure margins and corporate profits, which could lead to an increase in downgrades by major rating agencies, higher borrowing costs and, in an extreme scenario, a credit market freeze. In isolation, this growing debt burden isn’t paramount as long as credit conditions remain favorable.

But the crux of debt-based economies lies in the ability for individuals, local businesses and multinationals to readily gain access to credit and short-term funding.If credit conditions tighten considerably, it will accelerate the timeline and risk of recession, and at that point the catalyst won’t be nearly as important as the aftermath.

If panic over the coronavirus outbreak spreads, we can expect to see more supply chain disruptions, quarantines, mandated company shutdowns and, as a result, more uncertainty and unrest. The longer the hysteria lasts, the higher the risk companies will fall behind on servicing sizable debt loads, which could unleash a far greater fear to asset prices than fear itself. Any material threat to the economy will provoke more extreme responses from monetary and fiscal policymakers, driving demand for hard, scarce assets. Bitcoin and gold are the big winners in a world of fiat currency abundance.