Disconnect between markets and the economy: what's going on?
By Dr Ben McCaw, Senior Portfolio Manager
All too often, words like “unique” and “unprecedented” get thrown around too casually. However, they’re near enough to spot on when describing this year’s market and economic events.
The speed and severity of falls across share markets, and spikes in volatility, in March, were unlike anything that has been seen since the 1930s. Likewise, the deliberate shutting down of economies and normal social interactions to curb COVID-19 has been unprecedented.
The fight against the pandemic is far from won or over, and activity across major economies hasn’t snapped back to anything like normal. Yet, despite all this, share markets and other risk assets rebounded remarkably in the June quarter.
The US S&P 500 Index closed the June quarter about 20% higher than it began, its best quarter return since 1998.1 Over the same period, the global and Australian share markets, as measured by the MSCI ACWI Index and S&P/ASX 200 Accumulation Index, respectively, also recorded double-digit gains.
An upshot is that these share markets are now not far off their mid-February highs. Unpacking all this isn’t straight forward, but here are some thoughts.
Leveraged investment strategies came unstuck in March
For starters, it might be useful to return to the causes of March’s extremes, before going on to discussing the current situation and how we’re managing portfolios.
The widely accepted explanation for what happened is well known and the short version goes something like this.
Markets went into a tailspin on the heels of decisions by governments to put economies and industries into hibernation, and communities into lockdown. Add to this cocktail a lack of visibility on the end-date of lockdowns, and, above all, profound uncertainty over the path of the pandemic and what transpired in March seems a logical, albeit brutal outcome.
This is a reasonable explanation, but not a complete one, in our view. Technicalities within complex global markets also contributed to the mayhem. The chief factor being the role of leveraged investors.
For most of the post-GFC decade, leveraged portfolio strategies across fixed income, equities and other assets classes re-emerged with strength. Making this possible were ultra-low official interest rates and quantitative easing, which suppressed asset market volatility, whether that be in share (Chart 1), fixed income or currency markets.
Chart 1: Share market volatility was low for most of the post-GFC decade
US S&P 500 Index: Implied and realised volatility*
*Realised 30-day volatility is the trailing 1-month volatility of annualised S&P 500 daily returns. Realised volatility measures the degree of variation in the price of a security over a given period. In this case, 30 days. Implied annualised 30-day volatility is the CBOE Volatility Index (VIX), a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. The VIX, often termed as the "fear index," is calculated in real time by the Chicago Board Options Exchange (CBOE).
Data is to 13 July 2020
However, the speed of events in March overwhelmed highly leveraged investors.
As volatility shot up across asset classes, correlations rose (note that government bond yields went higher, for a time, as share markets sold off in March), many leveraged investors were forced to cut equity exposure. This led to further share market slides in a destructive, self-perpetuating feedback loop.
This, we believe, is the less well-known explanation for what happened in March.
Central banks’ put
Yet, here we are, just a few months later and markets have done an about-face. Not much has fundamentally changed in economies, but share markets appear to have underestimated economic uncertainty as well as the continuing disruptive power of COVID-19.
Many countries have succeeded in flattening the infection curve, but COVID-19 is advancing in the US, Brazil, Russia and India, all countries with large populations. The UK too seems to be losing ground again.2
So, what’s driven the share market bounce? Two words, “central banks.” They’ve effectively “doubled down” on the policies that propelled risk assets for most of the post-GFC decade.
The “Greenspan put”, a reference to former US Federal Reserve chairman Alan Greenspan’s tendency to sooth investors, at the first sign of market ructions, has been replaced by the “Powell put.”3
Of course, the US Federal Reserve hasn’t been on its own with a raft of measures to reassure markets and support economies.
The amount of support through global central bank stimulus (and government spending) has been estimated at a staggering US$18 trillion (A$26 trillion),4 with interest rates slashed to 0% or below (after taking inflation rates into account) in most major economies.
It has meant, amongst other things, that borrowing costs for high-grade US companies are now below January levels.
In a zero-interest rate world, returns from term deposits and governments bonds are unappealing to savers and investors. Consequently, investors are compelled to go further up the risk curve to try and earn positive returns.
The liquidity unleashed by the US Federal Reserve and its central bank counterparts has smothered price discovery — the process by which market prices are determined, largely by interactions between buyers and sellers — by backstopping every conceivable asset.
This was exemplified by the fact that US car-rental company Hertz’s stock price rose in June after it declared bankruptcy. Truly mind-boggling stuff.
At times like these, investors grounded in the importance of fundamentals like valuations, cashflow reliability, interest cover, robustness of business models can seem quant, and out-of-step with the times.
Investors also have ringing in their ears the adage “Don’t fight the Fed” because if central banks are in fully fledged “whatever it takes” mode, markets would appear to have an in-built saviour.
But true investing isn’t about blindly riding momentum created by central bank liquidity. Investing, to our way of thinking, is the art of risk-management — extracting the highest possible unit of return for the least amount of risk.
Economic uncertainty will persist until COVID-19 is beaten
Right now, there’s plenty for investors to mull over, despite central banks. One measure of uncertainty is found in the high dispersion of earnings expectations for the US S&P 500 Index (Chart 2). The 2008/09 GFC period was the last time of such widely dispersed earnings expectations.
Ordinarily, earnings expectations are within a tight range, especially further out into the future. But as Chart 2 makes plain, sell-side analysts are far from agreeing on US company earnings, even on an 18-month time horizon.
Chart 2: Currently, there is high dispersion of earnings expectations
US S&P 500 Index earnings expectations over next 12 and 18 months: aggregated standard deviation of analyst forecasts compared to aggregated mean
As at 30 June 2020
Source: IBES, Datastream
The wide divergence of views is understandable. It’s true that the recent easing of lockdowns across the US lifted morale, as well as hopes for an economic rebound.
However, figures like the US unemployment rate falling to 11.1% as the economy added a record 4.8 million jobs in June,5 while encouraging, can’t be taken in isolation. The American economy is still down nearly 14.7 million jobs since February and the number of Americans filing for unemployment has increased to 19.3 million.6
With the spread of the COVID-19 virus accelerating in the US, many economists expect the recovery to be bumpier and job gains more muted.
Small and medium-sized businesses account for around 50% of US employment.7 A second wave of disease would certainly spark another round of job shedding and insolvencies.
A recent New York Federal Reserve study found that only one in five small businesses can survive a two-month loss of income.8 Many such small businesses are even cutting back on rehiring as they reopen.
For the hardest-hit sectors, things may never return to normal. Another recent survey found that 17% of US hotels and restaurants, which are big employers, believe their revenues will never return to pre-COVID-19 levels.9
The pandemic dominates our investment scenarios
While at most points in time the investment outlook relies on multiple sources of uncertainty, the next 12 to 18 months pivot around COVID-19. Consequently, our thoughts on short-term scenarios are all sub-versions of the main global pandemic scenario:
- Pandemic: Short disruption: No second wave
o The northern hemisphere summer (Australian winter) helps rid the community of COVID-19. No substantial second wave of infections arise and seasonality does not emerge.
o Lockdowns end with only mild earnings implications for this year and next.
- Global pandemic: Drawn-out lockdown with mild second wave of infections
o A mild second wave of infections arises across the globe. Partial lockdowns are re-established.
o Earnings suffer in both FY20 and FY21. Currently, rising infections in Texas, California and Florida suggest that economic and earnings normalisation could further out.
o Hospitality and other impacted sectors are severely disrupted.
- Global pandemic: Drawn-out lockdown with severe second wave
o A severe second wave of COVID-19 emerges. Full lockdowns are re-established.
o Fiscal and monetary stimulus near the point of exhaustion.
o Populism gains more strength.
o High risk of deep and persistent economic malaise.
Rise-hedging extremely important
Many competing forces at work and investment professionals must be nimble to steer their clients’ portfolios through this complicated situation.
Share markets could keep rising, lifted by the amount of money flowing through the financial system. Against that are uncertainties because the pandemic is unbeaten and economies can’t return to normal until it is.
Thankfully, the way we invest isn’t reliant on us successfully guessing what the future may look like. Many investment organisations set out to forecast the future and position portfolios accordingly. Typically, they’ll have a base case as well as an optimistic case and pessimistic case.
Rather than thinking of what’s ahead as just a handful of possibilities, we’ve developed 40 investment scenarios through our Investment Futures Framework. The Investment Futures Framework applies to MLC’s multi-asset portfolios — MLC Wholesale Inflation Plus, Horizon and Index Plus portfolios. The range of return outcomes that run off the back of the Investment Futures Framework is vast and forces us to be intensively aware of risks in each situation.
It also means that we’re not trend followers, which is especially important now when uncertainty dominates. For our multi-asset portfolios, we’re choosing to adopt particular investment strategies to manage the current uncertainty.
Rather than going all-in, or avoiding risks at-all-costs, we’re choosing to increase our exposure to investment-grade credits (corporate bonds issued by companies with strong finances), as they provide exposure to companies’ cash flows, but with lower risks than would be the case if we bought their shares.
We’re also choosing to participate in share markets through derivatives such as swaps and options, rather than buying shares. Again, we’re doing this because of our risk focus. By using swaps and options, our clients’ portfolios can benefit when share markets rise, earn a return when they fall, or be cushioned from the full impact of market falls.
Derivatives enable us to invest humbly. Using derivatives is an open acknowledgment that we’re uncertain about market direction and thus hedging against downside risks is important.
Recently, we used an option strategy to access a major emerging share market as an investment within our broadly diversified multi-asset portfolios. The option would have delivered an 11% return for that part of the portfolio, at the time of purchase.
At the same time, we also put in place a “put option,”10 just-in-case that market went down. If the market had gone down, we would have lost some of the 11% return at the time of purchase, but the hedging strategy would still have allowed us to keep some of the upside, contributing to the portfolio’s overall return.
Cash is usually regarded as a defensive asset, but can in fact turn out to be an extremely expensive one if share markets are running hard. Derivatives, by contrast, provide us with enormous flexibility irrespective of market direction.
Our in-house derivatives team is the most significant change that’s taken place in MLC’s asset management capability since the GFC. It has been integral to our management of client portfolios through the mayhem of March and will remain important in the months and years ahead.
Our derivatives capability is another component of our belief in the importance of diversification across many dimensions. It reflects our risk-management heritage and the care we exercise in managing clients’ funds.
1 'Financial fragilities': We have just been reminded about how vulnerable the global economy is. Stephen Bartholomeusz. The Sydney Morning Herald July 1, 2020. https://www.smh.com.au/business/markets/we-have-just-been-warned-about-just-how-fragile-the-global-economy-is-20200701-p557yv.html. Accessed 1 July 2020.
2 For detail see Johns Hopkins University & Medicine, Coronavirus Resource Centre. https://coronavirus.jhu.edu/data. Accessed 2 July 2020.
3 Jerome Powell is current chair of the US Federal Reserve. America’s central bank and equivalent to the Reserve Bank of Australia.
4 'Fasten your seatbelts': Sharemarket mayhem set to continue. Marc Jones, Sydney Morning Herald, 30 June 2020. https://www.smh.com.au/business/markets/fasten-your-seatbelts-markets-have-had-a-wild-six-months-and-more-is-to-come-20200630-p557fb.html Accessed 30 June 2020.
5 The US economy created 4.8 million jobs in June. But that's not the whole story. Anneken Tappe, CNN Business, July 2, 2020. https://edition.cnn.com/2020/07/02/economy/june-2020-jobs-report-coronavirus/index.html. Accessed 4 July 2020.
7 Small business the canary in US economic coal mine. Rana Foroohar, Australian Financial Review, 29 June 2020. https://www.afr.com/policy/economy/small-business-the-canary-in-us-economic-coal-mine-20200629-p5575q. Accessed 30 June 2020.
10 A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an underlying security at a set price at a certain time. A put option is typically a bearish bet on the market, meaning that it profits when the price of an underlying security goes down.
 The Investment Futures Framework is MLC’s unique scenario-based portfolio construction approach applied to manage the MLC multi-asset portfolios, also known as the “MLC Investment Trusts” —including MLC Wholesale Inflation Plus, Horizon and Index Plus portfolios.
 A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an underlying security at a set price at a certain time. A put option is typically a bearish bet on the market, meaning that it profits when the price of an underlying security goes down.
This communication is provided by MLC Investments Limited (ABN 30 002 641 661, AFSL 230705) (MLC) as Responsible Entity and member of the National Australia Bank Limited (ABN 12 004 044 937, AFSL 230 686) group of companies (NAB Group), 105–153 Miller Street, North Sydney 2060.