The speed of the sell-off and subsequent recovery has had a significant impact on investor psychology, which looks back on the lows of March 2020 as a time when investors forgot two of the great post-financial crisis rules of thumb; ‘Central banks will come to the rescue’ and 'Tina – There Is No Alternative (To Equities)’.
Stimulus will come to the rescue
As March 2020 unfolded, each day felt like it saw a fresh round of monetary or fiscal stimulus as authorities reacted to the absence of buyers in most major markets.
Economists argue over the exact catalyst that started the rebound in risk appetite that drove equities from their lows, but it was most likely to be investors concluding that the sheer weight of stimulus was more than sufficient to cover even the most bearish of Covid-19 outcomes.
Investors were convinced that, should it be needed, governments and central banks would continue to provide more and more stimulus.
‘Moral hazard’ refers to a situation where a party to an agreement does not suffer the economic loss of a risk and therefore may take the risk without consequences.
This view became prevalent among market participants who adopted the opinion that falling assets would ultimately be propped up, or even bought by central banks, should the situation continue to worsen.
Arguably, this has reinforced investor behaviour rather than created an entirely new mindset.
Since the financial crisis, bad economic news has often been associated with a good stock-market outcome as investors price in additional stimulus or more accommodation for a longer period of time.
During times of concern over the past 18 months, investors have priced in additional accommodation within the bond market rather than reflecting poorer news in lower equity prices.
The view that central banks and governments are in some way underwriting risk within asset markets could be quite dangerous.
It comes at a time when authorities are attempting to transition to a more normal world, at least partially weaned off the ultra-cheap money required to stimulate demand last year.
Looking ahead to 2022, a central bank ‘policy error’ is one of the greatest risks to financial markets. At the heart of this is the conundrum faced by central bankers: do they react to the risk of inflation proving 'stickier' or do they want to look beyond what may well prove transitory.
At the same time, central bankers clearly want to take steps to remove some of the pandemic support that propped up markets last year, given the economic progress made within many developed market countries, as well as globally.
