Synchronized global central bank & fiscal policy stimulus in Q2 was breathtaking. Near term, it is stunting the carnage caused by Covid-19, including economic growth plunging at a rate not seen since the Great Depression. It is also an affirmation of the jaw-dropping power of printing money and the impact across asset markets, both explicitly, and implicitly through the confidence channel, has been unprecedented. Understanding how those channels work is critical to understand how we got here and what to anticipate going forward.
Equity Shocks in Perspective
For perspective, the past two recessions, roughly one and two decades ago, shocked the equity markets to the tune of drops in the S&P500 of -49% and -57% respectively. The time it took for equity markets to claw back to pre-recession peaks was 6 ¾ and 5 ½ years, respectively.
While the final numbers for this Covid-19 episode are not yet in, the rally off the lows has been breathtaking in both speed and magnitude. In just 77 days, the S&P500 rallied 50% from its Mar. 23 low, to return to a level just 5% below its Feb. 19 peak.
This stands in stark contrast to economic growth prospects. GDP for 2020 in the US and most developed economies is likely to come in a minimum 7%-12% lower than was expected in February, even including a “beautiful” reopening of the economy.
Stretched Valuations Swept Aside by The Money Machines
This raises the question of stock market valuation. If equities were richly valued in February on a price-to-earnings basis, a price-to-sales basis, and a sales-to-book basis, what is fair value in this new world, wherein earnings are revised down by 15% from last year, and by 25% from expectations in February?
The answer is nobody knows! Such is the power of liquidity and financial repression, the effect of which is to inflate valuation multiples. By normal metrics, the massive rebound in equities appears stretched and vulnerable to substantial setbacks. That is especially true given a lack of clarity from many companies choosing to withdraw future guidance. However, these are not normal times.
Investors have chosen to sweep aside concerns about both stretched valuations and risks to growth from possible future virus flareups. The great enticement to do so has been the power with which authorities have turned on the great money machines since late March and kept them humming.
The amounts are mindboggling. The Bank of Canada expanded its balance sheet by 300% in the Feb. to Jun. period. In the US, the Fed balance sheet jumped by $2.5 trillion with fiscal stimulus and Fed lending facilities to business amounting to almost 15% of GDP. Accompanying the greatest surge in money supply into economies on record, has been lower interest rate levels. With central banks buying not only public but corporate bonds, credit markets have been flung open for corporations to raise otherwise unattainable volumes and rates on new financings.
With heaps of cheap money flooding the marketplace, investors threw caution to the wind. Tossing aside concerns about how much further stock markets might fall, investors shifted into hyperdrive about the upward blue-sky potential.
In sum, the perception of “risk” suddenly flipped like a switch from the downside to the upside.
What Happens Next? – Faith in The Money Machines
The animal spirits currently driving investors seem to fit under the mantra Fear Of Missing Out (FOMO) backed by There Is No Alternative (TINA). This is a difficult mantra for investors striving to be prudent.
The FOMO mantra is all about momentum, whereby upside begets more upside, until it falters. Some recent market price action suggests that some of the extraordinary cheap liquidity is being drawn in on a highly speculative basis.
FOMO has a friend in TINA. Where else to invest? Bond yields in nominal and real terms have collapsed. As an alternative to stocks they appear pricey with tight credit spreads and in many cases negative interest rates. TINA also supports the view that stock market setbacks are likely to be temporary. That means, “buy the dips”. In this context the question is when to buy, not whether to buy.
Clearly the current paradigm demands faith in the Money Machines. Investors must believe that the political will remains firmly in place to keep the machines oiled and running. For their part, monetary and fiscal authorities must continue to “guarantee” that they will not fade in their provisioning of stimulus for the foreseeable future.
Equally important, investors must remain fixated on the short-term. Taking a longer-term view would belie the high risks associated with this paradigm. High stock market valuations imply lower longer-term returns. Higher public deficits and debt are borrowings against the future generation, implying lower future net incomes. Further, high liquidity levels at low rates are a cocktail for high variability in asset prices over time.
This article is provided for informational purposes only. It is not intended to provide specific financial, investment, tax, legal, or accounting advice to you, and should not be relied upon in that regard. It is also not predictive of any future market performance. These views are presented at this moment in time and are subject to change without notice. You should not act or rely on this information without conducting proper and complete due diligence.
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