MARKET COMMENTARY

Making Connections Out Of The Disconnect

06.09.2020 - Ronald J. Sanchez, CFA

Key Takeaways

  • There has been much attention on the “disconnect” between the state of the economy and financial markets; we view markets as functioning normally.
  • In our view, markets have become highly connected to two driving forces: the path of the virus and the global policy response to the crisis.
  • We believe that markets have adopted the best-case scenario—an unabated economic reopening, no second wave, a restoration of demand and employment, and meaningful progress towards a treatment—without much margin for error.
An Opening Comment

We are truly operating in unusual and challenging times. As investors programmed to view world events through a singular and unemotional lens, we assess their financial impact to consumers, businesses and corporations. The focus of this piece is to share our perspective on the ongoing narrative surrounding the disconnect between equity markets and the US economy. At the same time, we are acutely aware of the pain and suffering that recent developments have taken on a human level. People’s lives are not merely data points but carry far more meaning and significance.

Stocks as a Leading Indicator: Aim for Where the Puck Will Be

As we sit here today, the S&P 500 Index has essentially returned to its pre-coronavirus levels, and it is as if the dramatic selloff earlier this year never occurred. Headlines about the perceived disconnect between the US economy and the stock market have been popular recently. While the S&P 500 has gained 44.5% since March 23, some 24 million Americans have lost their jobs.[1] How can the stock market rally following more bad news about retail sales, industrial production, or labor markets?  

We would argue that there has always been a difference (disconnect) between stocks and the economy.  It may also be useful to remember that equity markets are forward-looking pricing mechanisms that anticipate future economic growth. Today’s stock prices don’t necessarily reflect what has just occurred, but instead show investors’ impressions of the potential impact further down the road. 

To quote NHL Hall of Famer Wayne Gretzky, “Skate to where the puck is going to be, not where it has been.”  The market sets its sights on where the puck is likely to be down the road, not on where it is today. If investors focus too much on the present, they risk missing the puck and a possible equity rally.  

Perceived “disconnects” between current news and market prices can be either partially or wholly explained by the fact that the information was already expected, and markets are now looking well beyond the latest headlines. Investors attempt to anticipate the prevailing economic environment and its impact on future market prices. These expectations are guided by current developments, trends and incoming data. From this continually evolving mix of information, market participants adjust their expectations as conditions change.

Fundamentals Take a Back Seat

There are unique factors driving markets today. Investors have been thrust into an unusual world in which analysis based on economic and corporate fundamentals has been substituted with analysis of a global pandemic and corresponding massive monetary and fiscal support. The inherent nature of this crisis has been truly remarkable and a historical first—a sudden shutdown of the world’s largest economy owing to a health crisis and a gradual, phased restart. In effect, markets were left to grapple with the fallout from flipping a switch “off” on a $22 trillion light bulb and trying to switch it back on again.

The near instantaneous shutdown of global economies led to an apparent crater forming between “today” and “tomorrow,” and in a manner and speed which was nearly impossible to fathom previously. The US went from essentially peak employment to Depression-era unemployment, seemingly in the blink of the eye. The unemployment rate moved from 3.5% at the end of February, to 14.7% by the end of April, with 24 million people losing jobs in just a four-week span. That pace stands in stark contrast to the more gradual shifts typically seen in the economy, even during the Great Financial Crisis when net payroll losses totaled roughly 8 million workers over a two-year period.

Traditional data—i.e., nonfarm payrolls, industrial production, and even corporate earnings—typically used by market participants to assess the economic picture have been made largely irrelevant.  With the market moving quickly alongside policy actions, traditional data releases have become akin to the slow drip of a leaky faucet. That stark comparison between forward-looking financial markets (Wall Street) and the latest data (Main Street) is certainly unusual but not irrational. In our opinion, that’s how it’s supposed to work.

With that said, no one would suggest that the present-day landscape is anything other than dismal. But investors have written off this year, looking past the economic destruction wreaked by the shutdowns. Instead, they have been investing based on next year’s expected economic and corporate environment, while remaining acutely focused on the path of the virus and the restarting of the economy. Embedded in current market valuations is a growing confidence that the world economy will stay on its reopening path, that no second wave will occur, and that the arrival of a medical solution is not too far off.

Making Connections

Over time, economic fundamentals and corporate earnings primarily determine returns. However, when investors consider what fair stock valuations are, other factors can influence market prices. In our view, markets have become highly connected to two driving forces: the path of the virus and the global policy response to the crisis.  

#1: The Curve of the Virus

For months, the  trajectory of the number of cases was seemingly the only data point that investors responded to, reasoning that if we continued on the path to a complete reopening of the economy, the economic data would follow suit and current data was only temporary. The chart below shows the spread of coronavirus cases shifting from China to Europe and then to the US, where the stock market started to regain ground prior to the flattening of the curve. Hence, a direct connection had taken hold between the virus and stocks. Markets have become fixated with the premise that an apparent light switch has been turned on and less on how bright it is.

Chart: Stock Rally in US Started before the Curve Flattened

7-Day New Coronavirus Case Growth as % of Total in the Region vs. S&P 500

Source: Bloomberg as of May 31, 2020.

#2: Global Policy Response

In reaction to the speed and magnitude of the market downturn, monetary and fiscal responses have been equally swift and dramatic in order to counteract the ramifications of mandated closures. Central banks opened their liquidity flood gates, and within two months released $11.3 trillion into financial markets, equal to 13.0% of world GDP.  Politicians moved in lockstep with central bankers, passing legislation that sought to support both businesses and consumers to the tune of $13.1 trillion (15.1% of world GDP).[2]  Today’s environment may represent the most favorable conditions in our lifetimes.

  • Market liquidity. The Federal Reserve and other central banks have poured cash reserves into the financial system, using a nearly bottomless tool kit to respond to the crisis. They have created favorable financial conditions and historic policy coordination, not only in the US but globally. So far, they have successfully prevented the worst possible market outcome (often referred to as a “tail risk”), by pledging unconditional market support. Investors have interpreted this as central bank protection of any market downside, essentially creating a price floor.
  • Fiscal thrust. Like the monetary efforts, the US Treasury and Congress have committed to spending whatever is necessary to ensure a full recovery in economic activity and employment. And markets have fully embraced this support.
  • Funding rates. It is obvious that short-term global interest rates will remain at or close to 0% until the economic recovery is on solid footing.
Where Do We Go from Here?

The narrative surrounding the disconnect has been intriguing. We would certainly acknowledge that the speed and magnitude of the recovery in market prices has been surprising and impressive but not necessarily irrational. With financial markets having made the full round trip from bull market to bear market and back again with the proverbial flick of a switch (and all within a 15-week timespan), we are left to wonder what’s next.

In our opinion, markets have priced in an optimistic scenario, but we are mindful that some tail risks may have been underappreciated. Will there be a second wave of infections? Will businesses fully reopen, and will enough consumer demand return to rehire currently sidelined workers? The lights are coming back on, but just how bright will they be?

These questions remain unanswered. We believe that markets have adopted the best-case scenario leaving little room for error. Our view is that the economic environment is improving, and the worst is now behind us (assuming no re-emergence of the virus occurs). The outlook for the recovery, however, remains highly uncertain and is likely to be protracted due to the uniqueness of the crisis. In the near term, we see limited upside in equity markets which seem likely to move sideways, with some volatility and perhaps even a pause in upward momentum. Although we cannot ignore the massive boost seen from historically favorable financial conditions, our intuition tells us to be patient as we await confirmation that the economic recovery has been steadied beyond the government’s lifeline.

[1] Source: Cornerstone, as of 6/5/20.

[2] As of 6/8/20.

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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