The Stock Market Is Not the Economy

The biggest challenge to navigating the current crisis is finding the right balance between news coming from health and humanitarian concerns, macro dynamics and financial liquidity. Over the last weeks, we have been communicating a lot about our negative view on the economy. Despite macro data coming in significantly below very low consensus expectations, equity markets have rebounded more than 25% off their lows. When stock markets rally on bad news, investors often lose a sense of reality. Currently, overly bearish sentiment, improving virus-related data, some optimism about reopening the economy and backstops from both the Fed and governments seem to be the main drivers of the brisk recovery in financial markets. Phrases that we have heard every day for years disappeared over the last few weeks, but FOMO (fear of missing out) and TINA (there is no alternative) are back in investors’ minds. Fear and greed drive prices more than fundamentals in the short term.

What’s Next?

The S&P 500 index just experienced the quickest meltdown in history, losing 33.9% in 21 trading sessions. All the leverage that had been built up during the longest expansion ever fed into a vicious and self-perpetuating cycle of volatility, liquidity and “risk-based” forced selling. During these uncertain times, investors are looking for maps to try to match the current situation to an historical crisis. Within a short time frame, the historical comparison went from 9/11, to the GFC and finally to the greatest of all market shocks, the Great Depression. However, looking at the historical data, the Great Depression offers no real comparison. During that time, construction of residential real estate fell by 82%, industrial production dropped 52% and deflationary pressures led to prices falling by 33%. Additionally,  its duration (number of quarters) was substantially longer than what we expect for this crisis. President Hoover refused to offer the help of the federal government, putting his main priorities in balancing the budget. The context couldn’t be any different. Today, budget deficits and debt levels do not matter, and central banks are stepping in harder and faster than any previous crisis to backstop funding markets and inject liquidity via repos, swap lines and QE programs. The Fed’s current asset purchase programme has eclipsed every other QE programme in notional terms in a span of less than four weeks. The life-or-death urgency of the situation has sparked an unprecedented monetary and fiscal response in terms of size, force and speed – necessity is the mother of invention.

Help for markets vs the economy

There is little doubt about the ability of governments and central banks to stabilise markets in the short run with their “whatever it takes” approach. However, we remain convinced that the rescue packages and stimulus are not enough to stop the economy from falling into a sharp recession. After the GFC, favourable capital market conditions and the hunt for yield led to a build-up of leverage on the premise that nothing bad would happen. By suppressing volatility and adding fiscal stimulus, these organisations have created a system that is very vulnerable to external shocks. Or said differently: they suppressed volatility, but they increased financial market fragility. COVID-19 unmasked an essential weakness in global finance, created by ten years of artificially cheap credit. And the only way out is to implement even bigger kitchen-sink policy actions, extending a lifeline to almost everyone looking for help. Ideas like helicopter money and modern monetary theory were ridiculed a few months ago, but mainlining liquidity directly into the veins of the global economy will be much more effective at boosting GDP than QE, which has largely injected liquidity only into the veins of the financial markets.

There is no limit

Markets got caught totally off guard by an external shock that happened at a time when sentiment was very bullish, systematic positioning crowded and the confidence in central banks very high. After the massive meltdown, which was to a large extent technically driven, the market is now focused on the massive support from the Fed, which is clearly determined to underwrite most risk assets. With its latest action, the Fed has reached a new level of moral hazard – nationalising excessive risk taking. Central banks act as a backstop for government, corporate and municipal bonds, and a move lower in spreads also brought a sharp decline in fixed income volatility. The sharp decline in the volatility of US Treasuries not only reflects lower realised volatilty, but also the potential for the Fed to implement some sort of yield curve control. But if all these actions are not enough, will the Fed start buying the ultimate risk asset: stocks? In the short run, fighting the Fed is a losing proposition.

Valuations remain expensive

The recent upswing might end like the bear market rally that started in October 2008 after TARP was passed, and which fully reversed into the market low of March 2009 due to the catastrophic collapse in economic and earnings data that followed. We continue to fear that the deterioration in macro data and earnings is not fully reflected in broad equity valuations. An earnings per share fall of “only” 13% year-on-year, would bring the S&P 500 index price-to-earnings multiple back to the levels last seen at the market peak in February 2020. Another headwind for equities is that the biggest buyer of the last decade, corporates, will be much less equity-friendly once their focus switches to ensuring their credit ratings. The recent moves in credit spreads wwere even more incredible than any other risk asset. Within three weeks, the focus moved from potential defaults of leveraged entities, rating downgrades, margin calls and forced selling to almost exclusively front-running Fed actions. We fear that, at some point, spread levels will need to face the economic reality of a real credit cycle. Valuations for risky assets might not matter in the short term, but it matters greatly on a 5-10 year time frame.