Is the hysteria that’s taken hold of financial markets justified?

Was the stock market slump on the last week of trading in February – which saw European shares and the Wall Street’s Dow Jones Industrial Average slump more than 12 per cent – merely an amuse bouche for the types of traders that thrive in volatile markets?

The combination of huge swathes of the northern part of Italy being put into lockdown in the early hours of Sunday to curtail the spread of coronavirus, setting a potential template for other western economies, and an extraordinary standoff between Saudi Arabia and Russia over how much oil should be produced sent financial markets into outright hysteria on Monday.

Monday night’s announcement by Italy’s prime minister Guiseppe Conte that restrictions on movement and public gatherings would be extended to the entire country isn’t likely to calm the markets when they open on Tuesday.

Deaths

"The markets are in a state of panic, with the perfect storm of a lot of bad news over the weekend in relation to the coronavirus in Europe and the US as well as developments in the oil markets," said Richard Flood, an investment manager with Brewin Dolphin Ireland.

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“The lockdown...in Italy is a wake-up call for the sorts of actions that might be required in other countries to get the virus under control – and what that will mean for the global economy. The threat of a recession in some parts of the world is undoubtedly rising.”

“The lockdown in Lombardy and neighbouring provinces in Italy is a wake-up call for the sorts of actions that might be required in other countries to get the virus under control – and what that will mean for the global economy. The threat of a recession in some parts of the world is undoubtedly rising.”

Oil prices crashed by as much as 30 per cent after Saudi Arabia fired the first shots in a price war, in crude’s biggest one-day fall since the early 1990s Gulf war. The Saudi move followed Russia’s refusal to sign up to production cuts with the Organization of the Petroleum Exporting Countries (OPEC).

While a 30 per cent slump in oil prices should ordinarily be a boost for gas-guzzling industries and consumers, it has made investors focus on underlying demand for oil in an uncertain economy.

The International Energy Agency (IEA) predicted on Monday that global oil demand will fall this year for the first time since 2009, when the world was still grappling with the financial crisis. While the agency had been predicting last month that demand would rise by over 800,000 barrels a day, it's now expected to contract by 90,000 barrels.

The IEA even spelt out a pessimistic scenario where global demand could slump by 730,000 barrels a day, assuming countries already affected by the virus recover more slowly, while the epidemic spreads further in Europe, Asia and beyond.

Quarantine

A key question in the oil markets now is whether Saudi Arabia is ramping up supply to hurt Russia and get Moscow back to the negotiations table, or whether the opponents are adopting their respective stances to target the highly-indebted US shale industry - now the world’s number one oil producer. That could spell a longer stand-off.

What could really spook financial markets could be ramifications for the US junk bond, or high-yield, market – a favourite fundraising ground for US shale operators. Energy companies account for 11 per cent of the US high-yield market, making them the biggest users of high-cost debt.

The fear is that if high-yield energy borrowers come under pressure to meet debt payments, it could prompt investors to flee this segment of the market, making it difficult for other types of heavily-indebted companies to refinance, according Aidan Donnelly, head of equities in Davy's private clients business.

Meanwhile, the sell-off in equities in recent weeks - with European shares having tumbled from all-time highs to enter a bear market in less than a month - has taken place against the backdrop of supply chains for components and raw materials from China and wider concerns about the impact of the spread of the virus on consumers around the globe.

Performance

Indeed, the strong performance by stock markets globally last year – led by the US, as it entered the longest bull-run in history – had been on the premise that companies, trading on relatively froth valuations, would return to profit growth this year, after posting little or none in 2019.

“We’ll probably see lower economic activity from consumers over the coming weeks, months, or even quarters, it’s probably more about people deferring spending rather than scrapping it,” said Donnelly.

Dublin-listed Dalata Hotel Group highlighted on Monday how it had become a victim of such, warning that it had observed “a significant reduction in bookings and an increase in cancellations following” the spread of Covid-19 in Europe.

“If it’s not a case of deferred spending and people actually batten down the hatches and spending doesn’t recover later in the year, it could be a different story,” said Donnelly. “Then you’ve got a risk of recession [internationally].”