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Stepan Lavrouk
Stepan Lavrouk
Articles (382) 

When the Cure Is Worse Than the Disease

The Chinese government’s reaction to the coronavirus outbreak is what is important

February 06, 2020

As anyone who has been watching the news recently knows, the market has been seriously shaken in recent weeks by the coronavirus outbreak in China. There have been a number of "hot takes" on the issue, with some claiming that the disease is less worrying than the seasonal flu, while others have much more dire forecasts.

I am not an epidemiologist (though I am by training a biomedical scientist), and neither are 99.9% of those commenting on the situation, so I will not venture an opinion on whether I think the disease will spread (and you should take all such commentary with a pinch of salt). However, I do feel confident in saying that the Chinese government’s response - which may or may not be unwarranted - will cause significant disruptions to the global economy.

Market breaks need a catalyst

Hindsight is obviously 20-20, but looking back, it does seem inevitable that with markets making new all-time highs and volatility being as low as it has been recently, some kind of correction was coming. Markets can become overvalued and become exuberant, but they will generally not break until there is some sort of catalyst. The response to the coronavirus outbreak - again, not necessarily the outbreak itself - may end up being this catalyst.

With millions of Chinese citizens and workers under quarantine, the disruption to supply chains has already happened - now it’s just a question of when this will flow through to company earnings. And in an environment where stock prices have become untethered from the underlying economic reality, this is even more important.

Liquidity injections

That said, it’s not so simple. The Federal Reserve, European Central Bank and the Bank of Japan have all stepped up their balance sheet expanding activities, with the Fed in particular engaging in extensive repo market operations. In a nutshell, these operations are a liquidity injection into the market, which results in an increase in asset prices across the board. Traditionally, central banks would only engage in such liquidity provision when there was some risk of a crisis or credit crunch. Nowadays, however, it seems like central banks need little to no excuse to get involved in the market.

So what we are left with is a push and pull between, on the one hand, disrupted growth, and on the other hand, the printing press that is monetary policy. All of this is happening against the backdrop of soaring equity values, in particular those of high-flying glamour stocks like Tesla (TSLA), which in recent weeks has taken its shareholders for a parabolic ride.

The cure is often worse than the disease, and I am not talking about the coronavirus outbreak. In the long run, trying to prevent every minor correction and slump in the market will come back to haunt policymakers and investors. Markets should be able to go down as well as up, and the longer we postpone the inevitable, the worse the recovery will be.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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