The first quarter of 2020 has been tough for the global economy in the midst of the coronavirus pandemic. For example, a record 35 million Americans have lost their jobs since mid-March and the UK had its largest jobless claims on record.
Meanwhile, growth has slumped as countries have gone into lockdown. The International Monetary Fund is expecting the global economy to suffer its worst downturn since the Great Depression.
Initially, equity markets crashed some 30% in the first three months of this year, reflecting the bleak prognosis for the economy. But they have subsequently rallied. For instance, the S&P 500 index of US stocks rallied 13.2% in April having collapsed 34% from its previous high.
It was the quickest and sharpest crash in stock market history followed by the biggest monthly gain in 30 years.
Understandably, people are confused as to why the stock markets are moving in the opposite direction to the economy. We spoke to Sean Markowicz , a strategist in Schroders’ Research and Analytics Team, and Stuart Podmore, a behavioural finance specialist, to find out why.
Why are markets rallying when the economic outlook is so bleak?
Sean Markowicz: “Equity returns across all companies and countries barely have any correlation with economic growth historically.
“A company’s share price is the reflection of all its future earnings. If there is news that could affect a company’s earnings, then its share price should move before it is captured in its financial statement.
“That’s exactly what’s happened here. Most of the bad news was captured in the market before we entered April as investors anticipated the economic slump before it has even been realised.
“For the same reason they have also captured the recovery, which is why we have seen share prices rebound.
“The markets have acted ahead of the release of official economic data, which is backward-looking. For instance, GDP figures are not released until after the quarter has finished.”
How accurately have markets reflected earnings expectations?
Sean Markowicz: “Although stock prices and the economy have not been aligned, the opposite is true of stock prices and earnings.
“If you take the fall in the S&P500 before the rebound, then that is roughly what analysts expect US corporate earnings to fall by this year.
“This is not expected to continue indefinitely. For example, in forecast earnings for 2021 are only 15% lower than they were at the start of this year and they’re only 11% lower for 2022.
“After the recent rebound, that 11% drop in earnings forecasts is the rough equivalent of the move in the stock market.”
What effect has government and central bank action had?
Sean Markowicz: “The catalyst for the market rebound has been the huge stimulus package launched by governments and central banks globally, which has created an even bigger disconnect between markets and the economy.
“The Federal Reserve (the US central bank) cut interest rates, pledged to buy government bonds in unlimited amounts, and unspecified amounts of investment grade (high quality) corporate debt and high yield exchange traded funds. In the meantime, governments have also provided an unprecedented fiscal response.
“This has been a huge support for the market even if it hasn’t shown up in any economic data or company filings. It has helped companies avoid a credit crisis in the interim and the same type of crisis we experienced in 2008.”
Are there any other factors at play?
Stuart Podmore “A hindsight bias among investors could be at play.
“In hindsight, it is tempting to believe we knew facts to be true about events before they happened. Sometimes hindsight shortcuts can be a positive thing and that might be going on here.
“It wasn’t so long ago that we experienced the global financial crisis. It is still in the memories of investors.
“They might be using the benefit of hindsight in a good way. They might be saying “I remember how important it was to invest in markets in March 2009, when the FTSE 100 was down to about 3700 level and it felt really painful. But actually I’ve got to consider this a buying opportunity.”
“That is backed up by a Schroders study conducted in the middle of April this year. The study of 100 Discretionary Fund Manager clients and 100 investment advisers showed that 97% and 80% of them respectively perceived this to be a buying opportunity.”
Are there any other reasons for the disconnect between markets and the economy?
Sean Markowicz: “The share of corporate profits as a percentage of GDP can change over time, depending on whether they grow faster or more slowly then other components such as wages or taxes. This is relevant for sectors and countries that have high export to GDP ratios. That means profits driven by global rather than domestic demand.
“US companies for example derive 30% of their revenues from exports but exports are only 12% of GDP. That can be a good or bad thing.
“International revenue can be a huge driver of growth. But during the pandemic it is unlikely to mitigate domestic issues because most countries have all but shut down their economies. However, if an economy reliant on domestic revenues gets back on its feet relatively quickly, then we could see a rebound in those countries who don’t rely so heavily on exports.”
Does the size of the company matter?
Sean Markowicz: “You can have enormous sectoral differences too within a market. The reason for that is because the market is weighted by the value of its constituents. The more valuable a company is in terms of market capitalisation, the bigger the index weight; the more effect its share price move has on the index as a whole.
“For example, the big tech stocks (Microsoft, Amazon, Google, Facebook and Netflix) in the US have vastly outperformed the rest of the market because everyone is at home using their services. They represent 20% of the S&P 500 index but their combined revenues in 2019 were only 4% of US GDP. So, although they have lifted the market because of their weighting, their economic footprint is substantially lower.
“The companies suffering most during the pandemic are small businesses, but they account for 44% of GDP, according to US Small Business Administration Office of Advocacy. Many of their problems aren’t going to be captured by the stock market because either the firms aren’t listed or their weighting is smaller.”
Is there a risk of a further correction?
Stuart Podmore: “In the past there have been three false recoveries during major equity sell-offs, so it’s possible we could see markets fall again.
“Until we are past the threat of a second peak or a mutation of the virus then there is always the threat of another correction.
“History tells us that. If you go back to the Great Depression in the 1930s, even before banks failed and unemployment peaked, the S&P 500 rallied 100% in six months before it corrected again.
What traps could investors fall into?
Stuart Podmore: “There are two dangers for investors. The first is overconfidence. What that means is, you are overconfident in your ability to produce returns by investing; you are better than the rest.
“There is also confirmation bias. Investors should look for evidence that disconfirms their view as much as it confirms their view. Otherwise investors can fall prey to confirmation bias, which is related to desirability bias, or in other words wishful thinking.
“It is going to take a while for confidence to return among most investors and businesses. It is one of the themes picked up in the “Inescapable Truths” recently published by Schroders’ Economics Team.
“After this crisis we could see higher savings rates and lower capital expenditure which might lead to lower growth. Lower-for-longer interest rates could also be a knock-on effect.
“If people don’t see the growth and the standard of living they have enjoyed in the past then we might well see increased disruption.
“There is no guarantee this will play out as it did in the aftermath of the financial crisis. History rhymes itself but it never repeats.”
