Commentary on Political Economy

Thursday, 28 May 2020

Recommended For Investors: Take Heed!

Sharemarkets definitely aren't the economy in these pandemic times
Stephen Bartholomeusz
May 28, 2020 — 12.09pm

The adage that the stock market isn’t the economy can rarely have been more apposite.

As the death toll from the coronavirus in the US topped 100,000, Wall Street's S&P 500 index broke through 3000 points on Wednesday. It’s now more than 35 per cent off its March lows and only 10 per cent off the record levels of February.

That’s despite soaring unemployment, plummeting corporate profitability, the biggest fall in consumer spending for more than 60 years, the lowest levels of consumer confidence since the global financial crisis, swelling spreads for high-yield bonds and very large slabs of the world's largest economy still in lockdown.

More like a casino than a disciplined conduit for capital: Sharemarkets have decoupled from economic reality in the pandemic.
More like a casino than a disciplined conduit for capital: Sharemarkets have decoupled from economic reality in the pandemic.CREDIT:NEW YORK STOCK EXCHANGE/ AP
The market’s resurgence also ignores the intensifying tensions between the US and China, with another flashpoint emerging in Hong Kong, collapsing global trade flows, the crash in oil prices, the severity of the economic threats in Europe, the largely-forgotten wild card of Brexit and the collapse of growth in China, the world’s engine of growth in the post-financial crisis era.

It also disregards the increasingly erratic behaviour of the US president, now threatening to shut down social media platforms because Twitter is fact-checking his untruths. (He could, of course, just stop tweeting).

Any of those issues, individually, would have caused market shudders in the past. Instead, investors are breezily buying stocks at a rate that points to a conviction that COVID-19 is a fleeting phenomenon and that, after a very sharp "V-shaped" recovery, the US economy will rebound instantly to its pre-pandemic condition, if not stronger.

The economic scars from the pandemic will last years, not the months that equity market investors are pricing in.
The market may not be the economy, but historically its performance has borne some relationship to the performance of the real economy.

The long-term profitability of the corporate sector is closely correlated to long-term economic growth. If the market reflects the aggregated performance of the companies listed within it, then it should track, even if loosely, the underlying economic conditions.

If it doesn’t, then it’s more akin to a casino than a conduit for capital and discipline on its efficient use, its primary purposes and worth to the economy have been relegated to secondary market trading that has little connection to the underlying economies.

The economic data in the US and elsewhere, including Australia, will get a lot worse before it gets better and the economic scars from the pandemic will last years, not the months that equity market investors are pricing in.

Even if there were a vaccine developed before the end of this year and it was available for mass production, which is unlikely, it would take years before the globe could be immunised, if that were even possible. Even if it is contained within the major economies, it would have left deeply negative damage on segments of activity and they would remain vulnerable.

Soaring unemployment, soaring valuations
In the March quarter, the US unemployment rate soared to 14.7 per cent as more than 20 million Americans became unemployed. The June quarter will be worse. The earnings of companies in the S&P 500 fell 13 per cent in the first quarter; the range of forecasts for the full year is for a decline of between 20 per cent and more than 30 per cent.

Yet the US market is trading at about 22 times current-year earnings against a historical average of 15.7 times and a historical median multiple of 14.8 times.

In more normal times, the US decision on Wednesday to end Hong Kong’s special economic status, which has seen it excluded from the tariffs the US has imposed on mainland China, would by itself have tanked the market. It presages yet another intensification of the Cold War developing between the world’s two biggest economies.

The bounceback in sharemarkets, including the ASX, began on March 23, when the Federal Reserve Board unveiled its $US2.3 trillion ($3.5 trillion) monetary policy agenda.

It has been helped by the massive fiscal response – $US2.9 trillion of spending announcements in the US so far -- and, more recently, by the cautious re-opening of some parts of the economy.

'Dangerously naive'
Even if the return to normal is successful – even if there are no new outbreaks and no second wave, which seems improbable – considerable damage to economies has already been done.

The Australian Prudential Regulation Authority’s Wayne Byers said overnight that the idea that central banks could apply some temporary measures "and then everything will go back to normal" was a "dangerously naive one".

He also said that measures to backstop liquidity had worked well and bought time, but solvency pressures were mounting as credit risks came to the fore.

That’s a fundamental question mark hanging over financial markets. What central banks and governments have done so far is to inject vast amounts of liquidity into their financial systems and economies. That defers issues of pandemic-generated insolvency, but doesn’t resolve them.

It is only when those temporary measures are withdrawn, scaled back or perhaps just not increased that the full economic costs will be laid bare.

A lot of businesses that went into the lockdowns as solvent enterprises will take years to recover; a lot of households’ financial capacity will have been significantly diminished; a lot of businesses and households that weren’t in strong shape to start with either won’t re-emerge or will be permanently impaired.

Liquidity, no matter how available, doesn’t resolve insolvency.

The damage, its unevenness, its severity and the timelines for some form of a "new normal" to emerge aren’t priced into equity markets, although sub-1 per cent rates for 10-year government bonds around the world and the spreads for higher-risk credits blowing out might suggest bond investors appreciate the risk of second-order developments and understand that growth will be much lower for much longer than their sharemarket counterparts appreciate.

Some of the world’s biggest and historically most successful investors have conceded they have no idea what is going to happen in economies and markets over the next week, month or year, and that would be true for all those investors pouring back into the markets since late March.

Normally, uncertainty equals risk and risk demands a premium that isn’t available in today’s markets.

The stock markets certainly aren’t their economies at this most uncertain of times.

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