The market is not the economy, and vice-versa:
- Recent market movements appear to conflict with underlying trends in the economy and increased COVID-19 spread.
- We continue to track the interplay between interest rates and gauges on economic activity.
- We retain our “glass half-full” outlook but respect the potential for volatility given news about ongoing stimulus plans, back-to-school dynamics and the upcoming election news cycle.
Global investors have digested considerable news flow over the past six months. While discussing the financial implications surrounding the COVID-19 pandemic feels trite, we are charged with helping investors think through how this year’s events may impact their assets. Prior to the virus’s outbreak, robust employment trends, simmering trade tensions, a tepidly growing global economy and sluggish corporate earnings growth were enough to propel global stocks to all-time highs in February following a strong calendar 2019 return. As investors reacted to what the novel coronavirus may mean for businesses, consumers and governments, global stocks lost 34 percent of their value in only 27 trading days, bottoming out four months ago to the day. Massive central bank intervention, bi-partisan legislative action, progress toward a medical solution and investor optimism have driven markets higher, with global stocks only down 3 percent relative to their record close in mid-February and the benchmark U.S. stock market index (S&P 500) registering a positive total return for the year. Riskier asset classes have staged a sharp “V”-shaped move, first lower and then higher, within a relatively short period of time.
While markets have staged a pronounced recovery, the global and U.S. economies have not demonstrated the same reflexivity. We track thousands of traditional data points for a read on the global economy, and in the current environment, we have incorporated several higher-frequency data readings to track economic progress, including physical restaurant seating, airport traffic and retail sales data. As you can see in Figure 1, while these data points have improved, they are well below pre-crisis levels and resemble a shape far from the “V” reflected in equity or stock markets.
Figure 1: Select High-Frequency Data, February 2020 – July 2020 (“YoY” means “Year over Year”)
Employment data offers another disconnect from the capital market reaction. Figure 2 below reflects the last five-plus years of the U.S. labor market as measured by the Bureau of Labor Statistics.
Figure 2: Initial and Continuing Jobless Claims, United States (in thousands), June 2015 - July 2020
Initial jobless claims show, on a weekly basis, the total number of former workers filing to receive unemployment insurance benefits for the first time, while continuing jobless claims represent former workers collecting unemployment benefits for at least two weeks. The blue line in Figure 2 (initial claims) displayed a historic jump higher as employers reacted swiftly to COVID-19’s realities and has since moved lower in almost “V”-like fashion. However, initial claims have not compressed to levels present prior to the coronavirus, and this morning’s release reflected a mild increase in initial jobless claims over the week prior. The gray line (continuing claims) has fallen from its early May highs, but its compression has stalled somewhat, and the “V” is far from completed.
Recognizing the above examples are a subset of the nearly infinite factor list surrounding economies, they do represent observable trends that provide frequent updates on growth trajectory. In a consumer-driven economy, understanding employment trends and activity levels is critical in gauging corporate profit prospects. So, if economic variables appear to be improving from depressed levels reached during the spring but are far below pre-COVID-19 levels, how are equity markets close to their all-time highs or in some cases hit new highs?
Our best explanation is what is happening with interest rates ― the cost of borrowing. Analysts look at two types of interest rates: nominal, or non-inflation-adjusted, and real, or interest rate levels that consider underlying inflation. Interest rates are the key driver of how financial assets are priced, including currencies, commodities, equity interests and debt interests.
If I invest in a stock or a bond, I am investing in a series of future cash flows, either in the form of interest payments or dividends. When interest rates are very high, the value of those future cash flows is lower; if a company offers a bond that pays out a nominal 4 percent coupon each year, but a government bond (backed by the taxing authority of a government) pays out a nominal 6 percent coupon, the corporate bond looks a lot less attractive. However, if the government offers a bond with a 2 percent coupon, that same corporate bond offers considerably more yield, even if it doesn’t have taxing authority.
Inflation is a risk to a bondholder. If price levels go up, but I am still receiving a fixed coupon over the life of the bond, the amount of “stuff” I can buy with my fixed coupon income goes down. Thus, understanding the impact that inflation has on nominal coupons or cash flows is critical. Further, because the United States retains its status as the world’s largest economy and the reserve currency of the world, U.S. government bond yields set the tone for interest rates and, therefore, asset prices, around the globe.
Policy measures enacted in response to COVID-19 across countries and regions featured one consistent theme: massive central bank purchases designed to keep borrowing costs low. This was the same playbook adopted during the 2008-09 Financial Crisis; consumers drive economies, so enticing consumers to buy now and pay later became the tactic. Since economic activity was so low both then and now, central bankers had less concerns about inflation risks.
Figure 3 shows the result.
Figure 3: United States Annualized Real Interest Rate Expectations, 12 Months Ahead (in %), January 1998 - June 2020
This chart reflects the public’s expectations of where real interest rates (nominal less inflation) will be one year forward. The public is pricing in modestly higher inflation in the next year relative to the level of nominal interest rates, meaning real interest rate expectations are negative. As you can see, we are back to expectations not seen since the Financial Crisis’ aftermath of low interest rates and a gradual, uneven global economic recovery. With real interest rate expectations below zero, the value of cash flows, even those that may be realized far off in the future, suddenly goes up. Couple that with fewer companies to own in public markets, due to ongoing public mergers and acquisitions while other firms are electing to remain private, investor capital is finding its way into a smaller supply of opportunities. While this low interest rate-low inflation phenomenon will not last forever, in the near term, it has placed a significant wedge between economic fundamentals and capital market performance, driving asset prices meaningfully higher before the data has reflected a marked improvement in underlying economies.
Markets are forward-discounting mechanisms, meaning they set prices today for uncertain future outcomes. With 102 days until an election day in the United States, much more information will follow. Before election day, markets are monitoring back-to-school dynamics over the next six weeks amidst still challenging COVID-19 spread, with concomitant implications for return to work. Even more acutely, investors await clarity from Washington on the next set of stimulus measures, since federal weekly unemployment benefits attached to March’s Coronavirus Aid, Relief, and Economic Security (CARES) Act expire in less than a week. With recent studies indicating that only 37 percent of total jobs in the U.S. can be done from home, Washington’s response on ongoing aid coupled with back-to-school and back-to-work trends will be important clues to corporate and consumer activity.1
While we retain a glass half-full perspective on diversified portfolios as we get closer to a medical solution to the COVID-19 challenges, we must respect the potential for volatility in coming weeks. We anticipate the news cycle to pick up from an already heady pace and encourage clients to engage us however we can help. We remain steadfast in our belief that patient investors will be rewarded for the risks they bear, and as always, we will update you with any changes to our views. Thank you for your trust.
1. Dingel, Jonathan and Neiman, Brent. “How Many Jobs Can Be Done at Home?” National Bureau of Economic Research, Working Paper No. 26948, April 2020, pp 1-8.