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United States -
Financial Markets vs Economic Data
July 2020
Introduction
Stock markets are expected to follow corporate earnings. Going by this assumption, the record plunge in the S&P 500 index in February did not come as a surprise. A recession was looming at the time (we are in a recession now, according to the Bloomberg recession prediction model) and corporate earnings only go one way when there is an economic downturn. The markets bottomed out on 23rd March and, since then, have rallied over 30%, much to the surprise of many macro-economic value-driven investors. A deeper dive into this stellar performance reveals a few possible reasons for this apparent disconnection.
Disappointing economic data
Millions of Americans have filed for unemployment benefits since the outbreak of the virus and these numbers are truly unprecedented in comparison to previous recessions. Head of U.S. economics at Bank of America, Michelle Meyer, told the New York Times:
“It’s literally off the charts. What would typically take months or quarters to play out in a recession happened in a matter of weeks this time.”
Just two months into the recession, the unemployment level in the country has jumped to almost twice what it was during the global financial crisis of 2008.
Source: Department of Labor
The nation-wide lockdown, imposed to curb the spread of the virus in late-March, has pushed many businesses to the brink of bankruptcy and these companies have taken draconian steps to cut costs, including furloughing or laying off employees. Century-old businesses are also being tested: rent-a-car giant, Hertz, filed for bankruptcy on 22nd May 2020 and has already made more than 20,000 employees redundant. The failure of such large-scale businesses is at the centre of the increases in the unemployment.
The abrupt end to normal business activities in the first quarter resulted in a record contraction of the American economy. This negative growth was not surprising, but economists were not expecting the decline to be as steep.
Source: Trading Economics
The spillover effects of this decline in economic activity have been felt by the real estate industry as well. For instance, new housing projects plummeted 30% in April, making it the worst month for the housing industry in recent memory.
Source: Bloomberg
Yet despite these disappointing numbers, American equity markets have rebounded.
Multiple reasons have led to this anomaly
Investor sentiment plays a major role in determining the directional movement of stock prices in the short term. Market performance in the last couple of months has been driven by various macro-economic developments that have led to an improvement in investor sentiment.
First, the stock market is a leading indicator, meaning that market performance is basically a reflection of what investors expect to see in future: while numbers have been disappointing, expectations for global economic growth are still high. In fact, the International Monetary Fund projects the global economy to grow by over 5% in 2021, which would make next year a record one for world economic growth.
Source: IMF/Bloomberg
Projections of stellar growth next year are expected to lead to a growth in corporate earnings, which would be good for equity markets. This belief has prompted many investors to ignore the current difficult realities and focus on a rosy future, which explains the disconnection between fundamental economic data and U.S. market performance over the last couple of months.
Second, market participants have celebrated the swift actions of the Federal Reserve to keep the economy from falling into an abyss. Many economists believe that Central Banks were late to act during the global financial crisis in 2008 and, consequently, this time around, the Fed has been more proactive. Below are some of the noteworthy initiatives taken by the policymakers to support the economy during these trying times:
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The Fed funds rate was cut to nearly zero in a move that saw interest rates plummet.
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Guidance have been issued to maintain policy rates at record low levels to help the recovery of the economy in the coming months.
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Quantitative Easing (QE) policies have been introduced to pump liquidity into the economy. For example, the Fed implemented an open-ended purchase plan of Treasury securities and government-guaranteed mortgage-backed securities.
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Through the Primary Dealer Credit Facility known as the PDCF, the Fed is offering loans to 24 large financial institutions in the country to support credit growth.
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A Money Market Mutual Fund Liquidity Facility has been established to lend to banks against collateral they purchase from money markets.
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The repo operations have been expanded by offering $1 trillion in daily overnight repo, and $500 billion in one month and three-month repo.
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The rate the Fed charges banks for direct lending have been lowered from 1.75% to 1.5%.
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The regulatory requirements pertaining to the lending activities of the largest commercial and community banks in the country have been relaxed.
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The Primary Market Corporate Credit Facility has been launched to lend directly to corporations by issuing new bonds.
Collectively, all these measures have improved the market sentiment as trillions of dollars have been provided by the Fed to save the American economy from this precarious situation. These proactive measures, therefore, are playing a critical role in the disconnection between economic data and the stock market performance.
Third, expectations for reopening of the economy have contributed to stocks’ resurgence. As of now, all 50 states are open, but with special guidelines to maintain social distancing, amonth other measures. The gradual opening of the economy since mid-April has improved the sentiment of investors by boosting expectations for earnings growth in the latter half of this year. Goldman Sachs recently wrote in a report:
“There are some small, early signs that life is resuming some form of normalcy. We expect these small signs of recovery to continue as the country gradually reopens and consumers resume their daily activities.”
Fourth, the largest constituents in the S&P 500 index, such as Amazon and Microsof,t are benefiting from the stay-at-home economy, which has, in return, led to a rise in their respective stock prices. While Amazon is experiencing record sales as the global e-commerce giant at the centre of grocery delivery in almost every corner of the world, Microsoft is benefiting from many companies embracing cloud computing to run their businesses smoothly while social distancing policies remain in place. Because the broad market index is reliant on large tech companies who are benefiting from the lockdown, overall market performance has not been as bad as investors expected it to be.
Conclusion
There is a disconnection between the American economy and performance of the stock market. However, a deeper study of this anomaly points to the fact that investors are looking into the future and are fundamentally optimistic. There is no doubt that the American economy will survive this scare, but investors need to pay attention to the overall valuation level of the market before getting too excited about its prospects. Warren Buffett, who has a reputation for gobbling up companies during recessions, is still sitting on a $140 billion cash, which could be an indication of further troubles ahead for the market and the economy.
About the author(s)
Harold Alby is a managing director and chief operating officer at Inova Capital. Justin Inniss is a managing director at Inova Capital. For more details on our insights please get in touch with us at Inova Capital AG on +41 415616905. Inquire about our ideas and nowcasting capabilities.