Phase 2: Financial contagion and feedback loops

The market reaction at the outset is to frame the dynamics of such an initial exogenous shock as constituting a sharp V that can be “looked through.” In the case of the coronavirus, it encouraged “buy-the-dip” investment behavior, anchored by recent experiences such as the September attack on Saudi oil fields and the U.S. missile strike in January that killed a senior Iranian general. But the ability to brush off mounting inconvenient truths is subject to a tipping point. In this case, that occurred last weekend with the spread of the coronavirus to Iran and Italy and its growing presence in Japan and South Korea.

Once reached, the tipping point launches technical market dislocations that have their own dynamics. This includes sharp downward price moves, forced deleveraging, and panic selling. The market for new funding starts to freeze and pockets of illiquidity become more pronounced. Pressures build on central banks from many sides to cut rates and find other ways of injecting liquidity, even though this does not address underlying causes but instead targets the financial symptoms.

The longer these financial dislocations persist, the higher the risk of contaminating economic and corporate fundamentals. The resulting pressure is particularly acute for companies, households and governments that need short-term access to funding due to low cash balances and maturing debt obligations.