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.

On mobile: review chart in landscape mode

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.

_____________

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.  

Want to know more about the Equity Markets?

Please contact us here:

15 + 15 =

Recent blogs
Technical Perspectives

Technical Perspectives

In last week’s blog we discussed the ‘Nasdaq whale’, Softbank, and the role it played, alongside an army of retail investors, driving tech prices ever higher prior to the recent correction. These short-term ‘technical’ flows are driven by the options market as traders look to hedge their underlying exposure, amplifying moves both lower and higher.

read more
A Speech For The History Books

A Speech For The History Books

In a speech for the history books, last week Fed chairman Jerome Powell announced a significant change to the way it conducts monetary policy by formally announcing ‘average inflation targeting’.

read more
Room to Run

Room to Run

Despite the fact the coronavirus has plunged many countries into recession, global equity markets are now back at all-time highs, as measured by the Bloomberg World Exchange Market Capitalisation index.

read more
Rising Phoenix

Rising Phoenix

In The Return Of Inflation (5th June 2020) we made the case for a transition from the existing deflationary narrative to one in which markets start to price-in inflation.

read more
All That Glitters…

All That Glitters…

The US dollar index, which represents the value of the dollar against a basket of developed market peers, fell through key technical support to its lowest level in 2 years.

read more
Q3 2020 Quarterly Perspectives

Q3 2020 Quarterly Perspectives

Despite suffering the worst pandemic in over a century, and the sharpest economic contraction since the second world war, global equity and bond markets staged one of the fastest recoveries of all time in Q2.

read more
The Return of Inflation

The Return of Inflation

Quantitative easing, or QE, is where a central bank creates money to buy bonds. The goal is to keep interest rates low and to stimulate the economy during periods of economic stress.

read more
The Powell Pivot 2.0

The Powell Pivot 2.0

In January 2019 Jerome Powell pivoted from a policy of interest rate increases and balance sheet cuts to interest rate cuts and, later that year, balance sheet expansion.

read more
Don’t Fight The Fed

Don’t Fight The Fed

Over the last decade, the Fed has increasingly resorted to unconventional monetary policy, such as quantitative easing, or QE, to stimulate the economy.

read more
Super Contango

Super Contango

In an unprecedented day in the history of oil trading the price of the front month contract for West Texas Intermediate (WTI) oil fell below zero to -$37.63.

read more
The beginning of the end?

The beginning of the end?

The coronavirus has brought economic activity to a virtual stand-still and transformed a strong global economy, with lots of debt, to a weak economy… with lots of debt.

read more
Halcyon Days

Halcyon Days

Today, global equity markets have fallen again and yields on developed market government bonds have collapsed even further. In my opinion, there are two diametrically opposed events playing out at the same time.

read more
A Time to Remain Calm

A Time to Remain Calm

This is a time to remain calm, patient and focused on fundamentals whilst relying on sound risk management practices. Over the last week the number of confirmed cases of COVID-19 has risen to more than 83,000 people across 50 countries.

read more
ESG in the Spotlight

ESG in the Spotlight

Environmental, social and governance (ESG), a byword for sustainability, has in recent weeks occupied rarefied real estate on the landing page of several finance industry titans.

read more
UK Growth

UK Growth

The long-term growth prospects for the UK economy remain positive and the uncertainties surrounding the Brexit negotiations will fade with the passage of time…

read more
Rational Exuberance – US Equities

Rational Exuberance – US Equities

Since its low on the 9th of March 2009, the S&P 500 has gained over 277%, the second longest and third largest gain on record. Understandably, many investors are concerned about the size and scale of the current bull market.

read more
UK Elections

UK Elections

Theresa May finally relented to the mounting pressure from within the Conservative Party and announced that a general election will be held on the 8th of June 2017.

read more