Coronavirus recovery: why the market rally makes perfect sense – but is likely to end in tears

Arguments that the rally in stocks is unjustified and built on weak foundations do not hold water, given the extraordinary measures taken around the world
The biggest risk is not that investors are complacent or irrational but, rather, the wave of global liquidity that is driving asset prices

Nicholas Spiro

Published: 12:15am, 14 Aug 2020

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On Wednesday, the benchmark S&P 500 equity index briefly surpassed its all-time high reached on February 19, just before the eruption of Covid-19 sent global markets into a tailspin. The dramatic recovery in stocks plays into the prevailing narrative that asset prices are dangerously detached from reality.

How is it possible, many financial commentators and investors ask, that the S&P 500 has gained 51 per cent since March 23 in the face of the most severe global recession since the Great Depression and a deadly pathogen that has infected a further 7 million people in the past month alone, many of them in America?

Even though stock markets are forward-looking and reflecting signs that economic activity – which in recent months has rebounded at a faster pace than many anticipated – will be much stronger in the second half of this year, the widely held view is that the rally is built on weak foundations and is unjustified.

This argument, though understandable given the devastation wrought by Covid-19, does not hold water when the extraordinary measures from the world’s leading central banks and governments are taken into account. Not only have policymakers acted more aggressively than during the 2008 financial crisis, they have provided investors with a firm pledge that policy will remain ultra-loose indefinitely.

The reaction in bond markets has been dramatic. The real 10-year US Treasury yield – which strips out expected changes in inflation from the nominal bond yield – has collapsed, falling from just over zero in late January to minus 1 per cent, a historic low. The last bastion of positive real yields and the world’s most actively traded government debt market has joined Japan and the euro zone in no longer offering investors a positive return.

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The financial consequences of the tumble in real yields are profound. Practically every major move in markets in the past several months can be attributed to the real-terms loss on the highest-rated parts of America’s debt market. Negative real yields caused the US dollar to suffer its sharpest fall in a decade last month, drove up the price of gold to a near record high and are underpinning stock market valuations, powering the recovery in US equities.

However, it is not just the unprecedented support by central banks, led by the Federal Reserve, that give the lie to the view that markets are behaving irrationally. Many of the sectors one would expect to suffer the most from a pandemic have been crushed. A gauge of airline stocks listed on the S&P 500 is down 47 per cent this year, while retail real estate investment trusts and casinos have lost 40 and 32 per cent respectively.

Conversely, the industry that stood to benefit hugely from a prolonged shutdown of economic activity and mass working from home has done spectacularly well. The New York Stock Exchange’s FANG + Index, which tracks the world’s largest technology companies, is up more than 50 per cent this year. With Big Tech accounting for 40 per cent of the market capitalisation of the S&P 500, it stands to reason that US stocks have surged.

There is a strong case to be made that, far from being detached from reality, markets are reacting more sensibly than before the pandemic struck. Where there is more scope for disagreement is whether the plunge in real yields has run its course, with markets starting to price in a sharper rise in inflation expectations given the massive injections of liquidity in the financial system.

Zero interest rates, heavy debt will mark pandemic recovery

Right now, the last thing on investors’ minds is a surge in inflation. Given the severity of the economic shock, deflation is more of a threat. Still, long-term inflation expectations in the US have risen more than a percentage point since mid-March to 1.8 per cent, while the 10-year Treasury yield is up 17 basis points since August 4. A more rapid increase in yields, potentially following a meaningful breakthrough on a vaccine, could roil markets.

The Fed is acutely aware of these risks, making it unlikely it would allow markets to be destabilised by a spike in bond yields. On the contrary, it is much more likely to pin down yields – even if inflation overshoots its 2 per cent target – to support America’s recovery, keeping real yields in negative territory for the foreseeable future.

However, policymakers’ unprecedented actions in response to the pandemic will also make it harder for them to wean markets off the monetary morphine when the time comes to begin withdrawing support. The gradual removal of stimulus was difficult enough in the years following the 2008 financial crisis.

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The Fed’s announcement in May 2013 that it planned to start unwinding its asset purchases spooked investors, triggering the so-called taper tantrum. This time, markets will be even more dependent on the financial morphine, especially if the surge in Covid-19 cases prolongs the damage to the global economy.

The biggest risk now is not that investors are complacent or irrational. It is that the wave of global liquidity driving asset prices is storing up trouble for markets.

Nicholas Spiro is a partner at Lauressa Advisory

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