Will the coronavirus be the trigger for a market correction?

The coronavirus has the world on alert. After the SARS epidemic killed nearly 800 people across 37 countries in 2003 causing a lot of panics and economic disruption along the way, there are serious concerns about another outbreak of a new coronavirus that has spread in Chinese cities, including the capital Beijing and Shanghai.

Currently, it's unclear whether the existing outbreak constitutes a public health emergency of international concern, which requires a coordinated global response. However, when looking at financial assets’ behaviour, there are clear signs of investor scepticism. 

Three weeks ago, the year kicked off with hopes that global activity would pick up after the US and China reached a trade truce and central banks showed no signs of tightening policy in the near future.

In this low yield environment, it has been wise to hold risk assets such as cyclical equities, especially as we have seen a steady improvement in US corporate earnings over the past week.

The argument against overweighting risk assets is that valuations are being overstretched, as many metrics for growth cyclical stocks have hit levels last seen in the late nineties “dotcom” bubble. But given that investors’ required rate of return is relatively low compared to that period and there’s still a significant amount of cash on the sidelines, there has been nothing to stop the current uptrend inequities.

The question being asked now is whether the outbreak of the coronavirus is likely to be a catalyst for a market correction. Today’s reaction reminds us of early February 2018 when the CBOEVolatility index (VIX) jumped by a record 20 points in one day. That move was unexpected and led to a sharp sell-off in risk assets with the S&P 500 falling more than 8% five days after the VIX spike; although we note it took only 11 days to recover all these losses.

With travel now halted from the Chinese city Wuhan, investors fear that the virus has already spread across the country and probably around the world. Chinese stocks are leading the losses in Asian markets today with the Shanghai Composite falling 2.85% at the time of writing. Oil extended declines to trade at seven-week lows, while US Treasury yields have declined across the curve.

While a minor pullback in assets prices may be healthy given this year’s strong rally, it remains to be seen whether the coronavirus is just a speed bump in the global risk asset uptrend or the catalyst for a steeper decline. We should know the answer in a few days, probably mid-way into the Chinese New Year. Investors will be clearly monitoring how fast the virus is spreading, the mortality rate and when a cure is likelybe found. In the meantime, expect to see volatility surging higher and further gains in safe havens such as Treasury Bonds and the Yen.