Markets seem to have been ignoring the fundamentals for some time, writes Julian Howard, but the gap between economic and market reality seems to have widened through the crisis, even as a deep depression looms large…
In the decade since the Global Financial Crisis, the schism between economic and market performance has been widening. Annual global growth has averaged less than 3% according to the International Monetary Foundation, yet the MSCI AC World equity index in local currency terms had breezily gained over 200% to 30 April this year.
Then, of course, coronavirus hit. Initially, markets saw waterfall slides worse than the first couple of weeks of the Wall Street Crash of 1929 - indeed, worse than every other market selloff in the last century. Forecasts of economic meltdown and depression proliferated; surely now the fundamentals would re-assert themselves?
Incredibly, markets turned around and the rupture between economics and markets has become a gulf. From 23 March to 30 April, the MSCI AC World index in local currency terms gained more than 25%, recovering well over half the fall since 19 February when the virus started to hit markets.
Even amid this emergency of all emergencies, risk assets were able to find a footing. For those investors who have always been taught that equities must ultimately follow economic growth and corporate earnings, coronavirus is merely the latest in a long line of similarly disconcerting episodes.
Many investors will be questioning why, and how, equity markets have become so impervious to fundamentals. Does the current reality mean that investors should simply hold a market index and stop thinking altogether, even as economic meltdown occurs?
Ironically, the roots of today's benign markets may lie in the prevailing state of economic stagnation we were already in before coronavirus, along with, we feel, the largely unimaginative policies that attempt to address it.
Prior to the pandemic, ageing populations leading to shrinking workforces, inequality suppressing consumption, and a lack of genuine innovation following the 1990s internet revolution were among the many drivers of stagnation, not to mention the lack of imaginative policy response and ever-easier monetary policy adopted by central banks around the world.
Coronavirus is unlikely to help matters, as global co-operation falls to new lows, while rushed fiscal expansion is bent on supporting economic structures as they were, rather than as they could be in the future.
Global central banks have been left trying to pick up the slack by further loosening monetary policy both conventionally (cutting interest rates) and unconventionally (quantitative easing, including mass corporate bond purchases). The resultant free money will not address stagnation, but for the time being it is likely to be the main policy response to the sizeable structural economic headwinds we face in the coming years.
Chart 1: Perma-mergency: central banks keep up the response
For investors, this has the perverse effect of supporting stocks through two mechanisms: the equity risk premium and net present value. In terms of the former, low to negative interest rates have created a yawning gap - the equity risk premium - between equities offering high earnings yields (over 4% for the S&P 500) versus the ‘safety' of bonds offering effectively no income (0.6% for the 10-year US treasury as at 30 April).
Market participants have given the phenomenon its own acronym, TINA, because There Is No Alternative for those looking for half-decent future returns based on yield-derived valuations. This assessment makes a broad case for risk assets collectively, but there is a more nuanced support mechanism in place for long-term growth and technology stocks in the form of the net present value (NPV) effect.
NPV is an accounting approach for valuing an asset based on its future revenue streams adjusted for prevailing discount rates. For stocks with earnings that are less about the near term and more about future growth, today's ultra-low to zero interest rates have a disproportionately beneficial effect, since they discount those future earnings back to a very high NPV.
This benefits growth stocks generally and technology stocks, while leaving ‘old world' cyclical value sectors like financials, energy, materials and industrials facing an uncertain outlook in the likely event that money effectively remains free for a long time.
Chart 2: Dispersion: coronavirus highlights stagnation's winners and losers
The unsettling conclusion of all this is that the long-term stagnation we have seen so far, and which coronavirus will only exacerbate, could possibly be favourable for many risk assets. This is a stressful concept for investors to grapple with because it is so counterintuitive.
There will, of course, be times when coronavirus and its aftereffects rattle the markets in the short term. Some shocking economic data should be expected in the coming weeks and months, and the market will have bad days. But low discount rates mean, in our opinion, that the accounting and financial metrics underpinning the equity market matter more than the economic ones.
One day in the future, this may change if stagnation is belatedly addressed. Only then might fundamentals re-assert themselves.
Julian Howard is head of multi asset solutions at GAM
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