Commentary on Political Economy

Tuesday 5 January 2021


Beware the gap between the grim reality of COVID and market optimism

It’s quite the list of bad news: The UK enters its third national lockdown as its hospital system reaches breaking point; US hospitalisations hit a record high; Japan considers a new state of emergency while WHO scientists warn that hotel quarantine will be a fixture for years to come.

They are the sort of headlines that you would expect to shake the optimism of even the staunchest market bull.

Traders work on the floor of the New York Stock Exchange.

Traders work on the floor of the New York Stock Exchange. CREDIT:MICHAEL NAGLE

But that’s not how the markets are seeing it.

The Australian share market closed out 2020 in largely the same place it ended 2019 after reversing its swingeing March declines. The benchmark S&P/ASX 200 index started the new year 1.5 per cent stronger, notching up the biggest rise recorded in two decades. Meanwhile, Wall Street ended the year on a high with the Dow Jones Industrial Index posting a 7.2 per cent annual gain. While the fizz in the markets has settled a touch the softness is hardly reflective of markets at panic stations.

Given the social, political and economic strife ushered in by the pandemic, it seems like quite the disjuncture. So why are traders not slumping into their Bloomberg terminals clutching their brows as markets rise and fall?

A few reasons, really.

The markets are positive a worldwide rollout of COVID-19 vaccines will be in full swing by mid-year. So much so that Qantas has started selling international tickets for flights in July. But given the warning WHO scientists issued last week that even with a vaccine, hotel quarantine will be a fixture for years to come, demand for the carrier’s flights could be crimped.

Another key reason is that central banks around the world including the US Fed and the Reserve Bank of Australia have been hard at work undertaking a mammoth quantitative easing (QE) program. Quantitative easing involves central banks buying large amounts of government bonds or other investments from banks to inject more cash into markets.

With more cash, banks can then loan more to businesses which in turn can expand their operations, increase sales and hopefully employ more staff.

RBA governor Phil Lowe and his deputy Guy Debelle.

RBA governor Phil Lowe and his deputy Guy Debelle. CREDIT:ALEX ELLINGHAUSEN

QE also drives down interest rates and in an already low interest rate environment, investors are finding that one of the few places where they can bank on respectable returns are stock markets.
Given markets are forward looking generally, the impact of QE has been priced into the value of many companies even if they are yet to report increased output as a result of the program.

There are some nascent signs QE and other stimulus measures are working. Fresh data out over the weekend shows global manufacturing improved in December with factories in Asia and Europe increasing their output as 2020 drew to a close, according to surveys of purchasing managers.

But QE doesn’t work if banks stop lending. And with the UK entering lockdown, Germany extending its pandemic-related restrictions and Japan about to declare a state of emergency, there is plenty out there to worry the international banks.

In Australia, the impact of the end of bank and landlord forgiveness periods in March and the phasing out of JobKeeper could crimp the recovery and make banks more risk adverse in their lending practices. While the surge in COVID-19 cases in Sydney and Melbourne appears to be losing force, it is a reminder that an economy-crippling return of the virus is always possible.

But there’s a new, unexpected element that could have a major impact on markets in the coming days. Once again, and indeed not for the first time this week, all eyes are on the US state of Georgia.

Georgia’s Senate runoff elections were expected by pundits and traders to provide a result where the Republican Party retained control of the US Senate. The markets usually prefer Republican-controlled senates that pass stimulus bills quickly and don’t introduce new regulation. The final composition of the senate will have a big say in just how the Biden administration wields its power.

And as it was with the US elections last November, Georgia may yet throw up some unexpected results.

The Republicans candidates –party stalwart Senator David Perdue and relative newcomer Senator Kelly Loeffler –were expected to snatch at least one of the two available seats, securing a Republican majority. Market watchers believe some traders are so convinced of a Republic victory it has added between 6 per cent 10 per cent to the market.

However, an increasing number in the market believe Democrat candidates Reverend Raphael Warnock and Jon Ossoff could take both seats, a sentiment that was reflected in Wall Street’s slip at the start of the week. Experts suggest the US market could suffer a downdraft of as much as 10 per cent if the Democrats pull off an unlikely win.

Like us all, traders are vulnerable to becoming armchair epidemiologists and armchair psephologists. It doesn’t mean they’re right. But given the gulf between market expectations and the grim reality of the coronavirus, and 2020’s ability to produce out of the blue results, it really is anyone’s guess.

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