The Stock Market and COVID-19

How COVID-19 is hitting the stock market?

The market has reacted to recent unpredictability with large drops, triggering a market-wide circuit breaker four times in March. The safeguard pauses trading for 15 minutes in hopes the market will calm.

The U.S. Securities and Exchange Commission mandated the creation of market-wide circuit-breakers to prevent a repeat of the October 19, 1987 market crash, in which the Dow plunged 22.6%. Since then, they have only been triggered once in 1997 before the four times this March.

The stock market has been in a sharp downturn in recent days as fears around the coronavirus spread across the global economy. And on March 16, stocks plunged once again.

If you don't follow the market that closely, or if you don't understand how it works more generally, it's hard to know what to make of this volatility. But the uncertainty raises a ton of questions, whether you've invested in the stock market or not.

Is a recession looming? How will this impact the average worker? Are we doing anything to fix it? And above all, will it get worse?To get some answers, I reached out to Claudia Sahm, a former Federal Reserve staff economist who's now with the Washington Center on Equitable Growth. She's an expert on recessions — what triggers them and what stabilises them — and a lot of her research explores the efficacy of previous stimulus programs.

We discussed if the economic fallout from the coronavirus will hit some regions of the country harder than others, if the stock market is causing our problems or just a sign of them, and if the Trump administration is doing anything to stop the financial bleeding.

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A lightly edited transcript of our conversation, recorded on March 12, follows.

It's no secret that the COVID-19 virus that most people know as the coronavirus has infected the U.S. stock market with fear and uncertainty, sending stock values on record-setting declines.

And most investors felt the shock. Market fears over the virus have hit specific industries harder than others, but nearly all sectors saw a drop in value. But you might be surprised to know that the market's reaction to the coronavirus isn't all bad, and smart investors are positioning themselves to exploit new opportunities.

Fear over the spread of the virus has affected most of our stock portfolios but believe it or not, and the effects are not always harmful. Smart investors use these types of environments to take a closer look at their investment strategy and tweak them wherever it makes sense.

Here are three ways the coronavirus will affect your stocks and how you can take advantage of your investment opportunities in an uncertain market. It was Wall Street's worst day in more than a decade: Stocks plunged on Monday as a panic that began in the oil market made its way through the global financial system, adding to concerns from already rattled investors about the state of the worldwide economy.

The S&P 500, already down 12 per cent from its late February high, fell more than 7 per cent on Monday. The sudden downdraft meant that trading in the United States was automatically halted early in the day — a rare occurrence said to prevent stocks from crashing — but it resumed after a 15-minute delay. The Dow Jones industrial average fell 2,000 points.

The drop on Monday was the worst for stocks in the United States since December 2008, when the country was still reeling from the collapse of Lehman Brothers and the housing crisis that dragged the economy into a recession. It put the index close to 20 per cent below its record high, a drop that would have ended the bull market for stocks that began exactly 11 years ago.

Asian markets opened mixed on Tuesday, in an apparent sign that investors were trying to regain their footing one day after the worst financial rout in years.

Global stock markets have sunk again despite central banks around the world, announcing a coordinated effort to ease the effects of the coronavirus.

The Dow Jones index closed 12.9% down after President Donald Trump said the economy "maybe" heading for a recession. London's FTSE 100 ended 4% lower, and other major European markets saw similar slides.

On Sunday, the U.S. Federal Reserve cut interest rates to almost zero and launched a $700bn stimulus programme.

It was part of coordinated action announced alongside the eurozone, the U.K., Japan, Canada, and Switzerland. However, investors are worried that central banks now have few options left to combat the impact of the pandemic.

The new governor of the Bank of England, Andrew Bailey, has pledged to take "prompt action again" when necessary to stop the damage to the economy from the coronavirus pandemic.

David Madden, a market analyst at CMC Markets, said that while central bankers were trying to calm the markets, "in reality it has the opposite effect"."The radical measures have sent out a very worrying message to dealers, and that is why they are blindly dumping stocks."

In New York, steep falls as markets opened triggered another automatic halt to trading, which is meant to curb panic selling. Before last week, such stops, known as circuit breakers, had not been used in more than two decades. But the sell-off continued after the 15-minute suspension, with the Dow losing nearly 3,000 points or 12.9%, its worst percentage drop since 1987.

The broader S&P 500 dropped 11.9%, while Nasdaq dropped 12.3%. All three indexes are now down more than 25% from their highs. In London, firms in the travel sector saw big falls. Shares in holiday firm Tui sank more than 27% after it said it would suspend the "majority" of its operations. BA-owner IAG fell more than 25% after it said it would cut its flight capacity by at least 75% in April and May.

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The FTSE 250, which includes several well-known UK-focused companies, ended down about 7.8%. The economic effects of the coronavirus outbreak and the preventive measures adopted around the world are still mostly unknown. Besides, standard macroeconomic models based on fundamentals may be slow to adapt in this fast-changing environment. This column uses high-frequency data on dividend futures to evaluate the impact on growth expectations. Dividend growth and GDP growth expectations in the U.S. and E.U. begin to deteriorate after the lockdown in Italy, and these effects are exacerbated by the travel restrictions imposed after that. The lower bound on dividend growth is as severe as during the Global Crisis, at least in the short run.

The outbreak of coronavirus has caused a pandemic of respiratory disease (COVID-19) for which vaccines and targeted therapeutics for treatment are unavailable (Wang et al. 2020). The outbreak has caused significant concerns about public health around the world. At the same time, there are growing concerns about the economic consequences as households are required to stay home to slow the spread of the virus. The impact that' pausing' the economy may have on supply chains, household demand, and the financial stability of the economy is mostly unknown. As a result, policymakers, businesses, and market participants are trying to revise growth expectations in the short run and the long run. 

As the current situation is unprecedented, and developing rapidly, models that use macroeconomic fundamentals may miss some of the key forces and may be too slow to update given the frequency with which macroeconomic data become available. It has long been recognised that asset prices may be particularly useful as they reflect investors' expectations about future payoffs. A natural starting point may be equity markets, bond markets (Harvey 1989) and credit markets (Gilchrist and Zakrajsek 2012). Indeed, much of the media commentary has evolved around these markets. In particular, the movements in the stock market have received a lot of attention. In a new paper (Gormsen and Koijen 2020), we provide a perspective on how to interpret movements in the stock market and what it tells us about growth expectations by combining it with asset pricing data from other markets. Our work relates to Ramelli and Wagner (2020), who look at the cross-section of stock price reactions to COVID-19 events to understand the factors that impacted investors' demand during the onset of the crisis. 

Equity markets in the E.U. and U.S. dropped by as much as 30%. This is an extraordinary amount. To interpret this decline, it is useful to recall that the value of the stock market is equal to the sum of the discounted value of all future dividends. For the stock market to decline by 30% only due to revised growth expectations, the shock to future dividends needs to be large and highly persistent. To see this, we can sum the dividend prices over the first ten years and find that this accounts for about 20% of the value of the stock market. This implies that if discount rates do not move and the economic impact on dividends lasts no more than ten years, a 30% decline in the stock market would mean that firms pay no bonuses in the next ten years – seemingly a rather extreme scenario. However, this is typically not the right way to interpret movements in the stock market. The seminal works by Shiller (1981) and Campbell and Shiller (1988) show that most of the variation in the value of the stock market is due to changes in expected returns, not revisions in expected future growth rates.

This insight brings good and bad news. The good news is that investors' expectations did not decline as dramatically as in the earlier calculation. The bad news, however, is that we learn little about growth expectations by taking cues from the stock market. Instead, we learn about investors' changes in discount rates that may be driven by shifts in risk aversion, sentiment, or uncertainty about long-run growth. In our paper, we show that data from a related market, namely dividend futures, is useful to obtain estimates of growth expectations by maturity. Dividend futures are contracts that only pay the dividends of the aggregate stock market in a given year.1

By no arbitrage, if we sum all dividend strip prices, they add to the market. There are two essential reasons that data on dividend strip prices are informative. First, van Binsbergen et al. (2013) show that estimates of dividend strips are right forecasters of dividend growth, GDP growth, and consumption growth. Second, and particularly relevant during this period, dividend strips are differentiated by maturity, just like nominal and real bonds. We use this feature of the data to provide an estimate of expected growth over the next year and to obtain a lower bound on the term structure of growth expectations by maturity.

We also derive a lower bound on expected dividend growth by a horizon, which can be computed directly using observed prices. The lower bound is entirely forward-looking and requires neither a forecasting model nor historical data, which makes it useful in our setting, and only relies on the assumption that expected excess returns have increased. The lower bound is plotted in Figure 2. The figure has the lower bound on the change in dividends scheduled on the vertical axis and the horizon on the horizontal axis. As of March 18, the lower bound is lowest on the two- to three-year horizon, where dividend growth has been revised down by as much as 43% in the U.S. and 50% in the E.U., compared to January 15. There are signs of catch-up growth from year four to year ten as the bound is substantially higher on longer horizons. We study how the bound evolves over the outbreak in response to news and policy initiatives, which gives insights into how financial markets interpret these events.

As of March 18, the lower bound on dividend growth is as low as what we observed during November of the Global Crisis – at least on the short end. On the long term, the lower bound is still not as low as what we observed during the Global Crisis, potentially indicating that investors expect the current crisis to be shorter. 

Earlier on Friday, markets in Asia had seen big falls, with Japan's Nikkei share index dropping by 2.7%. The 3.6% drop in the FTSE 100 wiped out the gains seen earlier this week on the index. Shares in travel companies again saw some of the steepest falls.

Banks also took a hit, as investors anticipate that interest rates might be cut to make borrowing cheaper for companies and consumers to keep the economy buoyant.

Energy firms were under pressure as well, after the collapse of a proposal by major oil producers to keep oil supply in a check sent oil prices tumbling more than 8%."The markets didn't even bother with the pretence of a calm start on Friday, bringing another rough week to a close," said Connor Campbell, an analyst at financial spread better Spreadex."The week's various central bank rate cuts only served to reinforce the seriousness of the situation."

Earlier this week, the Federal Reserve, the U.S.'s central bank, cut its benchmark interest rate by 0.5 percentage points to a range of 1% to 1.25% in an attempt to ease investor concerns. Many analysts predict it will cut rates again - perhaps as soon as its meeting this month. As traders seek less risky investments, they are turning to government bonds, sending prices higher.

The bond market - which is many times larger than the stock market - includes tradable loans to governments and businesses. Yields - how much investors will recoup in interest from the investments - drop as the price of the loan rises. Benchmark 10-year U.K. government debt now only offers a 0.24% return - a record low. In the U.S., the yield on a 10-year Treasury also fell to a record low, falling below 0.7%.

"With the 10-year Treasury yield slumping to a new record low and stock markets under pressure again today, it is questionable whether the Fed can wait until its scheduled meeting mid-month to deliver the next rate cut," said Paul Ashworth, chief US economist at Capital Economics.

A widespread temporary drop

First, and perhaps most apparent, we are all affected by a wide-ranging decline in stock portfolios. The ripple effect of coronavirus fears sent shock waves throughout Wall Street and blanketed almost every industry with fear and doubt, and those conditions are ripe for steep, but often temporary, losses.

Remember that smart investors invest for the long haul. Steep drops should not automatically be a cause for panic or selling of your personal portfolio. Instead, use this drop as an opportunity to keep yourself honest. After months of record-breaking stock market increases, investors, especially younger investors, may have forgotten that the market ebbs and flows. The market isn't always up.

This is your chance to knock yourself back into reality. Double-check your diversification. Talk to a financial adviser about opportunities to buy. Understand that despite the last several years of nearly constant growth, stock market investments are still inherently risky.

Many businesses have eliminated, or reduced employee travel in the hopes of stopping the spread of the virus. As a result, the demand for fuel around the world has decreased significantly, which has sent the price of oil down. Take a close look at the oil in your portfolio and diversify if it makes sense. Or if you're not currently invested in the energy sector, this may be an opportunity to buy.

Here's what not to do: Don't be fear-driven. This is an opportunity to re-evaluate your portfolio, talk to a financial adviser, and make changes — not to bail out entirely on specific sectors or overcommit by reducing your overall diversification.

Buying opportunities

Opportunities to buy up cheaper stocks in oil and manufacturing could be right around the corner as they begin recovering from the gut-punch of the sell-off. Pay attention to shares like CLX, -1.20% and Moderna Inc. mRNA, +4.94%, too, as people around the world suddenly begin to prioritise cleanliness and vaccines.

However, resist the temptation to overbuy at this juncture. We are still relatively early in the coronavirus effect, and it's very tough to predict how fears over its spread will influence stock market values in the future.

Why should I care if stock markets fall?

Many people's initial reaction to "the markets" is that they are not directly affected, because they do not invest money. Yet there are millions of people with a pension - either private or through work - who will see their savings (in what is known as a defined contribution pension) invested by pension schemes. The performance of these investments influences the value of their savings pot.

So significant rises or falls can affect your pension, but the advice is to remember that pension savings, like any investments, are usually a long-term bet.

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Alongside the Fed, five other central banks - the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Canada, and the Swiss National Bank - also announced measures to make it easier to provide dollars to their financial institutions facing stress in credit markets.

The move was designed to bring down the price banks, and companies pay for U.S. dollars, which has surged in recent weeks. Andrew Sentance - a former member of the Bank of England's Monetary Policy Committee, which sets interest rates - told the BBC's Today programme that banks were acting to ensure enough credit was flowing.

"There was some criticism around the financial crisis that central banks didn't move quickly enough," he said. "I see this as a partly precautionary action for central banks to show that they are doing as much as possible to keep the wheels of the economy turning."

Mr Sentance added that any further cut to the base rate in the U.K., to 0.10% for example, would be "symbolic, because it wouldn't have that much impact on companies or individuals".

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