SINGAPORE (June 5): The evidence of economic damage from the Covid-19 containment measures continues to pile up. Macro-economic data and individual company reports point to significant impact, yet share markets are roaring back to life. The divergence between the fundamental measures of economic health and the performance of stocks presents investors with a dilemma.
Gross domestic product is contracting in almost every country. Inflation is slipping, and unemployment is rising. The US official unemployment figure is now above 24 million people, and the government in China has not issued an official estimate of GDP growth this year for the first time in decades, citing Covid-19-related uncertainty. After recent corporate reporting, analysts globally have downgraded stock earnings estimates for the year by between 10% and 30% at the index level.
These macro indicators point not just to lost production, but also a higher degree of economic dislocation.
The share-market bulls respond that much of the disturbing economic data relates to the first quarter of the year, or possibly to April. They argue that it is backward-looking. The trouble with this argument is that leading indicators, such as capital expenditure intentions and Purchasing Managers Indices, are also pointing to contraction.
Some fundamental factors are clearly supportive. The enormous increase in global liquidity provided by central banks in response to the Covid-19 crisis removes a lot of risk from the global banking and payments landscape. A credit crunch was an important driver of the Global Financial Crisis, and the rapid response of monetary authorities illustrates the lessons learnt in 2008. However, the current concerns revolve around growth, not liquidity. The support from central banks is an important safeguard, but does not address the major issue of the Covid-19 crisis.
Fiscal responses from governments are also important. In ensuring that as many businesses and individuals remain solvent, they provide a cushion against the worst aspects of the decline in growth. This will offset losses, but in most cases governments can only support growth, not drive it.
It’s clear many investors buying shares right now expect economies around the world to spring back to life as lockdown measures are lifted. No one knows the future with certainty, and those buying stocks right now may be right, but this is arguably a highly optimistic view.
Share markets don’t reflect the present, they price in the future. Investors buy or sell stocks based on what they expect will happen. Further, prices are a function of crowd behaviour. If enough people believe an investment thesis, and act on it, the market will move.
Nonetheless, it is arguable that the lift in share prices from the March lows represents a triumph of hope over evidence. If an investor has never heard the terms “V-shaped recovery” or “snapback”, they have now. The idea that economies will quickly recover to pre-crisis levels once lockdown measures are lifted defies the experience of every market crash in modern history. Yet the idea is driving the extraordinary global rally in equities.
Hope is an admirable human quality, but a poor basis for investment. It’s natural that human beings want a brighter future, regardless of reality. This may explain the rally. It was largely driven by hope for a cure, hope for a vaccine, and hope for a short and consequence-free lockdown. At this stage, none of these hopes is real. In fact, as mentioned above, the hard evidence is running the other way. The big lift in share prices may have investors who noted the economic facts and acted accordingly, questioning their understanding of the investment world.
Markets can mislead. Because they are described with numbers, it’s easy to think that they are somehow mathematical, scientific or logical. Experienced investors know that the truth is very different. In the words of famed economist John Maynard Keynes: “The market can remain irrational longer than you can remain solvent.”
Sometimes investors must allow a market to play out. The data may be pointing to another leg down for equity markets. Regular reviewing of investment strategy contributes to better performance, but abandoning long-term goals due to short-term considerations is to fall into a trap. At times, the markets demand patience from those seeking superior returns.
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