Coronavirus recovery: hedging and market volatility show flaws in bullish narrative

While equity markets hail a rebound in economic activity and tech sector resilience, bond markets fear a severe Covid-19 shock driven by a spike in infections
If markets were really confident about the strength of the rise in economic activity, investors would not be hedging so aggressively against further turmoil

Nicholas Spiro

Published: 10:00pm, 16 Jul 2020

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The rally in global stock markets, which rebounded spectacularly following the dramatic pandemic-induced sell-off in March, is flagging. The MSCI All-Country World Index, a gauge of global equities, is up just 1 per cent since June 8. Even the CSI 300, which last week enjoyed its best run in five years, is losing momentum as foreign investors dump Chinese shares at a record pace, according to the Financial Times.

However, sentiment in equity markets remains upbeat. This is partly because of the unprecedented levels of monetary and fiscal stimulus to counter the economic fallout from Covid-19, but it is also because of optimism about the strength of the rise in economic activity as national lockdowns and social distancing measures are gradually phased out.

Bank of America’s latest fund manager survey, which was published on Tuesday, found that 72 per cent of respondents anticipated stronger global growth, the highest percentage since January 2014. Technology stocks were cited as the most popular trade-in markets by nearly 75 per cent of those surveyed, the highest share in the poll’s history.

Tech stocks have become a refuge for many investors as lockdowns and the persistent fear of the virus in the absence of a vaccine fuel demand for online shopping and streaming services. The New York Stock Exchange’s FANG+ Index, which includes some of the world’s biggest tech groups, has soared 50 per cent this year, compared with a 0.1 per cent fall for the benchmark S&P 500.

Yet, while investors pile into tech stocks, they are also parking their cash in traditionally safer parts of the market. Demand for government debt has surged since the pandemic erupted. The yield on the benchmark 10-year US Treasury bond has fallen 1.3 percentage points this year to 0.6 per cent, a whisker above its all-time low.

Although the collapse in bond yields is partly attributable to aggressive purchases of government debt by the leading central banks, it also reflects an especially bearish view about the prospects for global growth.

While the narrative in equity markets is about the stronger-than-expected rebound in economic activity and the resilience of the tech sector, the counter-narrative in bond markets is about the severity of the Covid-19 shock, exacerbated by the resurgence in infections in parts of the United States which presages a long and bumpy recovery marred by stops and starts.

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Both narratives cannot be right. The question is which one is a better gauge of underlying sentiment and a more accurate predictor of economic trends.

The rally by stocks in the face of the worst recession since the 1930s has been remarkable and may have further to run, especially if investors believe a vaccine against Covid-19 is within sight.

In a sign of how well equities have performed, the tech-heavy Nasdaq Composite Index has delivered the strongest returns this year, up 17 per cent, compared with a 10 per cent rise for US Treasuries, according to JPMorgan data.

Gold bullion is displayed at Shinhan Bank in Seoul, South Korea, in 2004. The price of gold, the ultimate refuge in times of stress, continues to soar. Photo: AFP

If markets were really confident about the strength of the rise in economic activity, though, investors would not be hedging so aggressively against further turmoil. In addition to sovereign debt, other haven assets are in demand. The Japanese yen has remained stable against the US dollar since the end of March, while the price of gold – the ultimate refuge in times of stress – continues to soar.

Even stock markets are sending mixed signals. Not only have most of this year’s gains been driven by a small group of tech stocks, levels of volatility remain elevated. All this suggests that the bearish signals from bond markets are more credible.

First, the resurgence in infections in several important states in the US has led to a rollback of reopening measures, which is tempering the rebound in economic activity. According to Bloomberg data, several high-frequency measures of activity have begun to deteriorate in recent weeks.

Federal Reserve policymakers, including Robert Kaplan and Lael Brainard, are now warning about a “second dip in activity”, with the spike in new cases having a “chilling effect” on the economy. Fear of a second wave, or the intensification of the first, is starting to snuff out America’s incipient upturn.

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Second, markets continue to underestimate the challenges in living with Covid-19. Kaplan has said massive stimulus can do little to help combat the virus if many Americans refuse to wear face masks.

In the US and Britain, which are among the countries hardest hit by the pandemic, resistance to measures to suppress the virus makes fighting it more difficult, particularly with US President Donald Trump in the White House.

Third, unprecedented levels of monetary and fiscal support across the globe, while necessary to boost demand, are causing a dramatic increase in public indebtedness in advanced economies. This will act as a further drag on growth in the coming years. It could also lead to a fiscal crisis if markets lose confidence in the sustainability of countries’ public finances.

Bond markets may be too pessimistic about the global recovery. Even if that is the case, though, equity investors’ own misgivings about the strength of the rebound are proof enough that the signals from debt markets are more reliable.

Nicholas Spiro is a partner at Lauressa Advisory

This article appeared in the South China Morning Post print edition as: How hedging and volatility undermine recovery narrative

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