In his book Alchemy of Finance, Hungarian billionaire investor George Soros puts forth an interesting concept called the ‘Theory of Reflexivity’. According to this theory, markets are reflexive. So, the beliefs held by investors tend to affect the fundamentals of the market and vice-versa. This reflexive mechanism forms a powerful feedback loop which can cause positive or negative outcomes, depending upon the herd or the collective thinking.
This theory, perhaps, could be the answer to the mayhem that the stock markets have witnessed over the past couple of days. Along with global markets that went on a downward spiral, India too saw its benchmark indices, Nifty and Sensex, falling by 8% each on March 12. The next day, the exchanges oscillated between hitting the lower circuit in the early hours to ending 4% (Sensex) and 4.5% (Nifty) higher after trading was halted for the first time in 12 years.“Have we ever seen something like this before? My memory doesn’t help me. Reasons for this volatility are very different from what we have seen in the past. Real world and real economy concerns led emotions are ruling the markets,” says Nitin Bhasin, head of research-institutional equities, Ambit Capital.
Bhasin’s statement is validated by the India VIX, a measure of investors’ risk perception, which rose by 22% in just a week to 80. Moreover, foreign portfolio investors (FPIs) have already pulled out 543 billion from the Indian capital markets this month, as on March 24. The latest pandemic has wreaked havoc on markets around the world as the MSCI All Country World Index shows a 30% fall from January 2020. In comparison, during the other disease outbreaks in recent times, markets did not react as sharply (See: Deadly diseases).
This emotional roller-coaster is courtesy Covid-19, termed a pandemic by World Health Organization. 184 countries, infected nearly 400,000 people and claimed the lives of over 16,500. In India, the first case was detected on January 30, and since then, over 500 have been infected while the number of deaths stands at 10. Rapid spread of the virus has prompted governments across the globe to enforce complete or partial lockdowns, close borders and pull the brakes on economic activities such as tourism, manufacturing or trade. Consequently, the impact of the viruson the global economy is estimated to be $1 trillion in 2020.
But let’s take a step back and look at the facts. Is the virus really as hazardous as it is being made out to be? Also, this isn’t the first time that the world is encountering a pandemic. Neither is this the deadliest or most infectious one. In fact, the mortality ratefor Covid-19 is 1-3% compared to 9% for SARS and 35% for MERS. Moreover, governments have been swift in taking proactive measures to curb its spread. Despite this, the financial and economic hit is unprecedented. What explains this irrational fear then? The answer lies in factors at play much beyond just the virus.
In his Washington Post column, Steven Pearlstein, an economics columnist argues that a market crash was inevitable, with or without Covid-19. He attributes this to the easy liquidity – trillions of dollars – pumped into the system by the Federal Reserve and other central banks in the aftermath of the 2008 financial crisis. The excess liquidity can in turn lead to a new round of financial and economic bubbles. As the central banks has already eased the taps of liquidity, there are concerns whether they can provide any short-term easy cash.
In addition, the prolonged trade war between the US and China led to uncertainty over global growth. Uncertainty over Brexit deal, tumultuous oil prices, and rising tensions between Iran and the US also kept optimism at bay.
The India story is no different. While the markets saw the longest bull run since the Lehman crisis, the rally in recent years was led by a narrow selection of large cap stocks trading at steep valuations and a hope of revival of economic growth. “For a long time, Nifty and Sensex were trading at a premium to long-term trading average. With this correction, Sensex and Nifty are trading at below their long-term trading average. This has led to valuation correction,” says Harshad Patwardhan, CIO – equity, Edelweiss Asset Management.
The narrow rally was accompanied by the liquidity crisis and collapse of financial institutions such as IL&FS, Yes Bank, PMC Bank and DHFL, making the situation pretty grim.Subsequently the wheels of consumption also slowed down.India’s Private Final Consumption Expenditure fell to 4.7% in December quarter, a cause for worry since it has averaged at 6.8% for over a decade and was at 7-8% even in the note ban and Goods and Services Tax (GST) years.
In fact, even before the Covid-19 scare, in July 2019, India recorded the highest outflow among emerging markets, with FIIs pulling out $2 billion. This was courtesy the budget proposal to increase tax on the super-rich, including foreign funds. Since then, the government has withdrawn the tax and introduced a slew of measures, including corporate tax cut, but has been unable to revive the investor and consumer sentiment. A combination of these factors has prompted economists to peg India's real GDP growth in the current financial year to be below 5%.
“Each time things blow out like this, it is always important to know the background. If for example the markets had been very cheap, or the Federal Reserve had a lot of ammunition, or the fiscal balance sheets were good, the reaction to Covid-19 would have been very different. You would have taken things in stride and moved on,” observes Manish Chokhani, director, Enam Holdings. That clearly wasn’t the case. The broader markets have been looking for a correction, and Covid-19 simply acted as a catalyst for this, in India and overseas.
The domino effect
It seems the pandemic has forced investors to pay attention to macro cues, much like during the collapse of Lehman Brothers in 2008.
Most fund managers compare the current volatility to the period during 2008 financial crisis and the months following the announcement of demonetisation and implementation of Goods and Services Tax (GST). “The extent and ferocity of fall are similar to the 2008 crisis but other factors are very different, like cheaper valuations, absence of small and mid-cap euphoria and lack of froth in earnings. Meanwhile, the current situation for India Inc can be compared to the temporary but deep economic shocks like demonetization and GST implementation, witnessed in the last five years,” says Vinay Paharia, CIO, Union Mutual Fund. These periods saw sharp falls and rapid pullbacks, which could happen with the current volatility as well if the virus is contained.
But if we were to compare it to a pandemic, then a parallel can be drawn with the SARS outbreak in 2002-04. It was smaller in scale than Covid-19 but spread more rapidly outside mainland China. Nearly 34% of the SARS cases were reported outside mainland China as against 0.91% in case of Covid-19, notes an India Ratings report. Despite this, the impact on financial markets wasrelatively small in 2003, with movements in the first half of 2003 hard to disentangle from Gulf War II, notes Macquarie. The moves were generally sharp but short-lived, with equity markets beginning to fall in mid-January. After the first case was reported in India inApril 2003, BSE Sensex dropped by 5% and then recovered around 30% over the next six months.
In contrast, global and Indian markets dropped sharply this time.
So why is there a disparity in the way markets reacted? Because, as India Ratings and Research notes, the impact of the 2003 SARS outbreak on global growth was partially mitigated by the fiscal and monetary policy room available to policy makers globally. However, Covid-19 comes against the backdrop of several global headwinds. “Thus, the ability of governments globally to stimulate growth remains limited and the impact on economic growth of the outbreak, if any, could be prolonged,” states the report.
Global headwinds apart, globalisation also is a key reason for this difference in reaction. Macquarie notes that China is now more important and integrated to the global economy than in 2003. Its GDP share is up from 4.3% to 16.3%; the number of Chinese travelling abroad increased from 16.6 million in 2002 to 162 million in 2018. China accounted for nearly 11% of the global imports and 13% of global exports in 2018. It also serves as an import supplier of various raw materials and intermediate goods and a transit hub for various supply chains in South and East Asia (See: Rule of the dragon).
Also, other epidemics, such as MERS, Swine Flu, Ebola and Zika were limited in their geographical spread, and thus had little impact on the financial markets.In contrast, coronavirus has made rapid strides across the globe.
Sentiments and Algorithms
While parallels can be drawn partially, it is important to note two things: the size of the economy today is much larger and growth is slower, making the ‘fear’ much higher. SARS had limited impact on the developed countries, while in 2008, the crisis was limited to the financial sector. “This time around, people are fearing for their lives and not livelihood and this is impacting the financial markets and in turn the economy in an adverse manner,” says Bhasin. Therefore, simply infusing liquidity or giving incentives will be of little help.
Even in terms of fundamentals, Chokhani states that this is the perfect storm. “Unlike previous crises, which came either from supply side or demand side, this time you are getting a punch from both sides. Lockdowns result in demand shock as people aren’t going out to consume, while on the other hand, stoppage of production will result in supply shock,” he says.
But the difference doesn’t end here. Mahesh Patil, CO-CIO, Aditya Birla Sun Life Mutual Fund, points to another reason behind the rapid fall.“The sharp fall in the markets may not have been completely due to fundamental reasons as quant funds, risk parity funds and volatility control funds which had been aggressive due to easy global liquidity were unwinding their positions amidst the high volatility,” he says. He adds that the impact on markets is more compounded this time than during SARS because of these differentiated funds which weren’t present at that point in the market.
Market veterans also blame the increasing advent of technology in trading for causing these sharp falls. Chokhani states that as much as 80% of trading in the world now takes place on an algorithm. Called passive investing, this is done by index funds and exchange-traded funds. These systems recognise patterns much quicker than humans, and thus, what would take 30-50 days to go into regular correction happens within 20 days. “The speed of response is like the spread of news in era of social media. And the computerised algorithms drive markets in an automated manner. Hence when the circuit filters come in even for 15 minutes, the direction of the market miraculously seems to change,” rues Chokhani, adding, “The bull and bear are no longer there. Now, the herd (via ETF flows) is the new bull or bear.”
Rays of Hope
The magnitude of losses only rise with each passing day that the metro cities remain in lockdown, and analysts do not rule out the possibility of a recession. A Morgan Stanley report states that 2020 global growth will dip to 0.9%, the lowest since the global financial crisis, when global growth bottomed at -0.5% in 2009.
“The disruption caused by Covid-19 on demand and supply side can potentially lead to global recession and that could lead to more credit defaults and prolonged pain for market. That is worst case scenario. But the best case would be that you should see it getting contained or peak out in next month. With liquidity around, things can stabilize and you could see a recovery in the markets,” says Patil.
Globally, central banks have realised the seriousness of the issue as seen from the coordinated monetary response across major economies such asthe US, China and Europe. The Fed has already slashed its benchmark interest rate by a full percentage point to nearly zero last week, dropped requirements for banks to hold a cash reserve and said it willpurchase $500 billion of Treasury securities and $200 billion of mortgage-backed securities to smooth over market disruptions.
Patwardhan points out that during any crisis, people tend to focus on the problem, but they forget that inevitably, crisis like these, bring in strong policy response from central bankers and governments in terms of fiscal measures. “That is why, after a precipitous fall in times like these, we also see a big rebound in the market,”he adds.
Further, the news might be dominated by the FII outflows, but one must also keep in mind that the SIP inflows have continued to remain strong. SIP inflow in February was at 85.13 billion, marginally lower than a record high flow of 85.32 billion in the previous months. “On a $2-trillion market cap, $4 billion of sale by FIIs is barely 2%. Plus with strong SIPs, Indian institutions have been buyers while foreign players have been sellers. This provides stability in a volatile market,” says Chokhani. But how long will the flow continue remains in question. According to Morningstar India data, all equity scheme categories — equity linked saving scheme, mid-cap, large & mid-cap, large-cap, small-cap, mid-cap and multi-cap are down 25-26% since February 19 to March 18. But what’s pertinent is that not just one month, one year, three year and five year return are also negative. So much so, that the jingle, mutual fund sahi hai, will get to the nerves of investors.
In India, the action of the government has been great in terms of optics. While the general perception is that India is ill-equipped to handle a health crisis, but the recent measures taken have surprised people pleasantly. “The Indian authorities seem to be managing the current situation quite well and proactively, in contrast to what has happened in Europe and the US,” says Patwardhan. Further, a Nomura report states that economies with strong linkages to China through trade, corporate earnings and tourism channels will likely suffer the most, and India is among the least exposed to the region (See: Surviving the pandemic).
As and when the situation improves, Chokhani points to two more positives that India could see out of this pandemic. Firstly, he says, there is a big re-balancing due. “It cannot be the case that the West continues to print notes and remain so leveraged and yet their currencies are seen as safe havens and keep appreciating. In the longer term there is potential for Asian currencies to appreciate over the West,” he opines. Secondly, he says, across the world supply chains have been so optimised that a breakdown in China leads to a shutdown in the world. Having learnt their lessons, companies could look to diversify their supply chain and India could be a beneficiary of this shift.
Now all depends on how soon the virus is contained. “Since the condition is still evolving, the extent of damage is not known. But the markets have corrected a lot. So, investors can take advantage of the situation by gradually increasing their exposure to equity,” says Patwardhan. His view is echoed by Patil, who opines that while there would be a downgrade to earnings, it won’t have a permanent damage on the business.
But it’s still early days to say what could be collateral damage as there is no precedence to this crisis.
However, history shows that while markets fall the fastest, recovery is always long-drawn (See: A slow grind). Given the extended shutdown across industries, GDP growth in the coming quarters is going to further head south. While clearly it’s not the end of the world, for now, the worst is far from over.