The great divorce

A question that engulfs the world at this point of time is, why stock markets are rallying when the economy is in toilets? This is not an outlier case of a single market or a region but across the globe we
are seeing this phenomenon. This blog tries to explore the reasons behind it and rationalize this decoupling.

Key Takeaways –

 Equity markets have recouped almost all of the losses incurred in 1H2020

 Among OECD and G7 countries, current unemployment rates are much higher than the long term average – driven by USA

 Forward looking nature of the markets are the primary explanation behind this exuberance

1. The Divorce

In 2020, much of the movement in equity markets was dominated by the pandemic when world indices dropped by 30% as of 23rd March on an average from the beginning of the year (Chart 1). Then till date, the world markets have recouped almost entirely the losses incurred albeit slowly than the rate of the fall. The contributors to the rally were US markets, Asian EMs and to some extent Europe where the extent pandemic containment showed fruitful results. This is the financial sector.

Source: Investing.com. Note: Values are normalized to 1st Jan, 2020 = 100.

Turning our attention to the real sector, we see that the monthly unemployment levels are at multiyear highs with exception of European Union, all other regions of the global economy are far above the longterm average (Chart 2). Real GDP levels too, paint a grim picture of the global economy where the forecast is for a record contraction in the growth rates in last 20 years (Chart 3).

Source: IMF, Author’s own calculations.

Source: IMF. Note: 2020 = IMF Forecast

2. The Probable Causes –

 Markets are forward looking

The basic fact that seats in the heart of the argument is that the markets are forward looking and the economic data points are what has happened in the past. When NSE moves from 9500 to 10000, it
means that the market players think that in future, NSE could be at 10000 and attaches a value to it.

While, when GDP is at 5% for say any quarter, it means in that past quarter, GDP growth rate was at 5% – not necessarily a value attachment to the upcoming quarters. So, when the markets bottomed in March, the players discounted and rationalized that the worst is over and expected the markets to bottom out and there will be an upward movement from that point. This brings me to my next point – accommodative monetary and fiscal policy.

 Accommodative Monetary and Fiscal policy

To keep the engine of the economy rolling (or any individual) cash is the primary necessity. With businesses closed, the global banks and govts. arranged and undertook loose policies like lowering
interest rates, announcing fiscal packages, direct cash transfers for the affected people etc. In addition, unconventional policies was adopted too like bond purchases that helped businesses to generate cash and access loans assisting them in keeping the ball rolling. These moves injected confidence in the market and since its forward looking, upward movement followed.

 Performance of technology, consumer and healthcare stocks

As the world moved to work from home setup, the technology stocks shot up at record highs. The FAANGZ (Facebook, Amazon, Apple, Netflix, Google, Zoom) contributed to record high rally in Nasdaq and contributed the majority in S&P’s rally. Globally FMCG and health stocks performed as expected since daily needs (specially sanitizers and masks) were met by the FMCGs while increasing hope of vaccines and related cures pushed up healthcare stocks.

 Re-openings

As the pandemic raged on, the recoveries were also a comfort zone in most of the countries which led to reopening of the lockdowns. Various points indicate that the economic activities are slowly coming back to pre-pandemic levels which gives comforts to the companies which were shutdown. Also, the reopening has the potential to bring back the employment numbers. Higher production can traction the earnings of the market and hence there remains plenty of reason for the markets to go up further by end of 2020 even when the GDP growth rates remain muted.

 Influx of 1st time investors

This has been another consequence of WFH or SFH when many people are trying their hands on the stock market. Some brokerage platforms added more than million subscribers during lockdown of which most are amateurs and little above amateurs. As money came in, the bulls got a significant lift. So, to conclude, the great divorce is evident and to some extent justified. The primary cause that
underpins this decoupling is the forward looking nature of the markets – everything stems from it. This decoupling is not recommended in classic macroeconomic text books where its mostly taught that the economy influences markets. Times have changed, so are the theories and we must try to internalize the fact that the books need a rewrite too.

In the end, something to think for the readers – given the govt packages (and subsequent budget deficits), ultra-low interest rates and simultaneously high unemployment rates, Who pays/is paying the alimony?

DISCLAIMER : Views expressed above are the author’s own.

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