Economy ≠ Markets

John Leiper – Head of Portfolio Management – 7th May 2020

One question I get from advisers and clients, more than any other, is why global equity markets have bounced back so far. Why have we not seen a continuation of the sell-off?

It is a good question because the data has been bad and will likely get worse. Case in point is unemployment levels in the US which have surged dramatically over the last few weeks.

On mobile: review chart in landscape mode

There has never been such a large gap between markets and the underlying economic data.

In fixed income, investment grade credit spreads should be much wider (and prices lower) than they are given the notable deterioration in the eurozone economy.

On mobile: review chart in landscape mode

The same is true in equity land. The chart below shows the 12-month forward earnings forecast for the S&P 500 (in red) and reported earnings (in white). The shown drop in forecast earnings is the largest in at least 30 years.

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Yet, despite this, the multiple for which investors are willing to pay for deteriorating earnings is the highest its been in almost 20 years.

On mobile: review chart in landscape mode

This disparity, between the markets and the data, is extraordinary.

It can be explained by the ability of market participants to look through the bad news and focus on the recovery. This approach is underpinned by two pillars.

Firstly, the number of new coronavirus cases globally is falling, and progress is being made in the hunt for a vaccine.

Secondly, and most importantly, governments and central banks have provided unprecedented levels of fiscal and monetary policy to support the economy, provide liquidity and sure-up investor confidence.

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Liquidity is a key driver of markets. The mechanism through which this operates is simple. An increase in the money supply leads to a monetary surplus which can be eliminated by increased demand for goods and services. This results in increased economic activity and a shift in risk appetite from low risk interest-bearing securities to higher risk assets like equities. Increasing the money supply also increases inflation expectations, further driving people into equities and other real assets.

As shown in the chart below, the US Fed has increased the money supply dramatically this year. On a month-to-month basis it is the fastest increase in over 40 years. Prior increases in the money supply, as highlighted on the chart, are also consistent with periods of weak economic growth and subsequent gains in the S&P 500.

On mobile: review chart in landscape mode

To increase liquidity, central banks are re-initiating quantitative easing programs. This is visible in the two charts below which show the year-on-year change in securities held outright on the Federal Reserve balance sheet, in red. QE5 is the large uptick on the right-hand side of each chart.

In each instance there is a clear correlation between the size of the Fed balance sheet and the blue line which represents fixed income credit and equity returns. The top chart goes as far as to suggest investment grade credit spreads could even go negative! Whilst that is extremely unlikely, the recent price action in commodity markets, which saw the price of West Texas Intermediate crude oil fall below zero for the first time in history, to -$40 a barrel, is a case in point. Admittedly that move was very technical in nature and the sub-zero price only applied to the May contract – more details here (https://blog.tavistockwealth.com/super-contango/). The bottom chart shows clear upside for equities. 

On mobile: review chart in landscape mode

The problem with this theory is that it could be time limited. Markets are pricing in the sharpest of V-shaped recoveries.

On mobile: review chart in landscape mode

Anything less could see a retest of the March lows. This might happen if we see a resurgence of the virus, following attempts to re-open the economy. In that scenario lock-down could be extended, further damaging the economy.

Unlimited liquidity is bullish risk assets but only on the assumption we return to something resembling normality. Unlimited liquidity can postpone debt problems but not fix them. If markets determine that the outlook for markets is morphing, from a crisis of liquidity to a crisis of insolvency, then risk assets could retest the lows in the coming months (something alluded to in last week’s blog:https://blog.tavistockwealth.com/from-liquidity-to-solvency/). If not, the sky is the limit.

Insolvency risk will be the focus of next week’s blog…

Until then, here is a quote from famous economist John Maynard Keynes: Markets can remain irrational longer that you can remain solvent.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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