Financial Market

Posted on January 25, 2022 by Cheapest Assignment

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COIT20251 - Assessment

Market volatility has ignited concerns of a recession caused by Covid-19. Business leaders need to look closely at market signals through asset classes to gain insights into the path ahead, but also look beyond markets to recession and recovery trends, as well as the trend of epidemics and shocks.

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Throughout different asset groups, Covid-19 risks have been priced so strongly that some fear a slowdown in the global economy could be a foregone conclusion. In different discussions, business leaders are wondering if the downturn in the economy really signals a recession, how bad a recession in Covid-19 will be, what the growth and recovery scenarios are, and whether the emerging crisis would have any lasting systemic effects. Projections and indices, in fact, will not address these questions. In the calmest of times, a GDP prediction is uncertain because the course of the virus is unclear, as is the efficacy of containment efforts and the reactions of customers and businesses. There is no single number that credibly captures or foresees the economic impact of Covid-19. Instead, to gain insights into the road ahead, we must take a closer look at market signals through asset groups, recession and turnaround trends, as well as the trend of pandemics and shocks.

Firstly, take risk asset assessments where the effect of Covid-19 has not been consistent. Credit spreads have risen remarkably little on a benign basis, indicating that credit markets do not yet expect issues with funding and financing. Significantly, equity valuations have fallen from recent highs, but it should be noted that they are still high compared to their long-term history. Volatility has signalled the greatest pressure on the opposite end of the continuum, intermittently bringing implied next-month volatility on par with some of the big misalignments of the past 30 years, outside of the international economic meltdown. Second, while financial markets are a relevant predictor of recession (not least because they can also activate them), history shows that it is not appropriate to immediately conflate bear markets and recessions. In fact, just about two out of every three U.S. bear markets overlap, i.e., one out of every three bear markets is non-recessionary.

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We have counted seven such cases over the last 100 years where bear markets have not coincided with recessions. There is no question that Covid-19 is now assigned considerable disruptive potential by financial markets, and those risks are real. The considerable volatility surrounding this epidemic is highlighted by the fluctuations in asset valuations, and history warns us against drawing a straight line across sell-offs from the stock market and the financial sector. 

What a Covid-19-Induced Recession be Like?

Usually, recessions fall into one of three categories: a real recession. Classically, there is a boom period of CapEx that turns to bust and growth derails. The real economy may also be pushed into a recession by extreme exogenous demand and supply shocks, such as conflicts, disasters or other disturbances. This is where Covid-19 has the greatest chance of infecting her host.

Recession in Policy. When the central banks keep policy rates too high compared to the ‘neutral’ rate of the economy, financial conditions and credit intermediation are tightened and, with a delay, expansion is choked off.

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Crisis in financial terms. Financial imbalances appear to build up slowly and through long periods of time, until the financial intermediation and then the real economy is quickly unwinding, disrupting. Globally, there are some marked variations, but financial crisis threats are difficult to point to in the vital U.S. economy. Taking a look at this taxonomy and experience again, there is some positive news in the classification of the “economic economy.” True recessions, while idiosyncratic, appear to be more benign than either policy recessions or financial crisis-induced ones, as they reflect potentially serious but ultimately temporary shocks in supply (or demand). In comparison, policy recessions can be serious, depending on the size of the mistake. Currently, probably the biggest policy mistake ever triggered the Great Depression. And the most pernicious type is financial crises since they introduce systemic issues into the economy that can take much longer to be corrected.

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 Economic Consequences Of Covid -19

Channels of transmission inform us how the virus takes control of its host. This is critical because various effects and treatments are inferred. Three possible channels of transmission exist:

  • Indirect hit to trust (wealth effect): household savings rates are rising as prices collapse and household wealth contracts and consumption must also collapse.
  • A direct hit to consumer confidence: While financial market results and consumer confidence are closely correlated, long-term data also show that even when markets are up, consumer confidence can drop. Covid-19 seems to be a potentially strong direct hit on confidence, keeping customers at home, tired of discretionary spending, and even cynical about the longer term.

 

The global financial crisis was, to demonstrate, a (very bad) cyclical case in the U.S., and it had a systemic overhang. The economy has stabilized, but household deleveraging is an ongoing secular phenomenon: household ability (and capacity) to borrow is structurally damaged, and the systemic collateral damage is that it is much harder for policymakers to push the cycle by controlling short-term interest rates currently.

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Could Covid-19 build a systemic legacy of its own? History shows that after a big crisis like this the global economy would probably be different in a variety of important ways.

  • Microeconomic legacy: The introduction of emerging technology and business models can be spurred by disasters, including epidemics.
  • Macroeconomic legacy: The virus threatens to accelerate progress towards more decentralized global supply chains, effectively introducing a biological dimension to political and structural forces.
  • Political legacy: Internationally, political implications cannot be excluded, since the virus measures the capacity of different political structures to better defend their citizens. Brittle structures could be revealed, causing political changes. 

What Leaders Should Do in Terms of Economic Risk

Financial markets perspectives and the past of comparable shocks can be operationalized as follows:

  1. Don’t become projection-dependent. Much volatility is currently expressed in the financial markets.
  2. 2. Do not allow gyrations of the financial markets to cloud judgment about the organization you lead. 

    3. Focus on signs of customer confidence, trust your own intuition, and know how to use the data of your organization in calibrating those insights. 

    4. Planning for the best and getting ready for the worst trajectories. Bear in mind that the realistic outcome, conceptually and empirically, is a V-shaped recovery, but don’t let that intuition make you complacent. 

    5. Start looking beyond the crisis. What is Covid-19’s micro macroeconomic or legacy going to have? What opportunities or problems are going to arise? 

    6. Consider how you are going to handle the post-crisis world. Will you be part of the quicker introduction of emerging technology, new methods, new technology?

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