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Why are markets up despite all the bad news?
‘Why is it that stock markets have not fallen further, given that the financial effects of the coronavirus are forecast to be so much greater than those of the 2008 recession, unemployment rates are forecast to be so high and dividend support is disappearing? Can it simply be attributed to government bailouts?’
Ian Conway, Senior Reporter replies:
While government bailouts are undoubtedly part of the reason why stocks seem to have stopped falling after the initial (albeit punishing) slump. Investor psychology is another major factor.
The stock market’s interpretation of economic data is often counterintuitive. Sometimes bad news is just plain bad news, but at other times bad news can be spun as good news because it means central banks will lower interest rates and bail equity investors out.
Faced with an unprecedented slowdown in global economic activity, investors – like economists and politicians – have absolutely no idea how bad the crisis could get.
When we see poor economic news, like an unprecedented surge in jobs claims or a collapse in industrial activity, the numbers are so bad it’s hard to fully grasp them.
The fact that the data is backward-looking also means we can console ourselves that at some point the news will get better, therefore we should be looking forward and ‘buying the dip’ so that we don’t miss out on a market recovery.
Therefore, surprise at the sudden increase in US jobless claims – 26m in the last four weeks – is tempered by the expectation that the people who have been laid off will get another job as soon as the crisis is over.
Similarly, the cataclysmic fall in preliminary US, UK and European purchasing managers’ surveys for April – simultaneously the worst readings on record and the sharpest ever monthly contraction in global activity – can be overlooked on the basis that the readings ‘have to’ improve in the next few months.
Even if that were the case, it will take much longer for actual levels of economic activity to recover, and to reach anywhere close to pre-crisis levels could take years rather than months.
Where corporate earnings and dividends are concerned, another unfortunate tendency is for investors to ‘look across’ the divide, writing off this year’s numbers as an anomaly and betting on a juicy recovery next year.
Analysts are typically reluctant to cut their earnings forecasts, and without any clear guidance from companies they have begun with baby steps, shaving their estimates by 10% here and 10% there so as not to look like outliers.
In the US, analysts have been somewhat more aggressive, with 12-month forward estimates for large cap S&P 500 company earnings having been cut by 17% on average in the last month. Small caps have seen a 30% cut on the basis that they are less well-capitalised and therefore more vulnerable in a downturn.
At the time of writing, the S&P 500 index had rallied nearly 30% from its March low, meaning investors are paying significantly more than they were a month ago for less earnings this year.
Having been told that they need to invest for the long term, investors are doing just that, looking forward to a big recovery in earnings once the US economy begins to reopen. The new buzz phrase is ‘exit strategy’.
There is no doubt that government and central bank intervention has boosted the markets.
The US government has committed $2.9trn of aid to the economy, the equivalent of 15% of US GDP, while the Federal Reserve has committed over $2trn in lending. Fed chairman Jerome Powell vowed that the bank ‘would never run out of ammunition’.
In unleashing an unprecedented wave of stimulus, buying low-grade corporate bonds to stop them falling into ‘junk’ territory, the world’s central banks haven’t just thrown out the rule book, they have jumped up and down on it, set it on fire and then thrown it out.
They are also buying ‘junk’ bonds and bond ETFs, and there are suggestions that they could even buy equity stakes in struggling firms in ‘strategic’ industries such as energy and defence. As Bloomberg reporter Katherine Greifeld puts it, this is ‘a lesson in how risk works in a vacuum’.
These central bank actions have worked in distracting investors from the worst economic outlook in decades, but by sending a message to the markets that risk assets are effectively backstopped, they have reinforced the ‘bailout culture’ and created enormous moral hazard.
Neil Birrell, chief investment officer at Premier Miton Investors, says: ‘At the moment it’s difficult to know just how bad an employment number, or any other economic data point needs to be to hurt markets.
‘As bad as it sounds, another 4.4m initial jobless claims in the US is not it, whilst the government and the Fed are standing firm. Policy versus reality, for now policy is winning.’
In other words, investors could keep ignoring bad economic data for months until it looks as though conditions are normalising and government support is providing a ‘cushion’ to the economy and to corporate earnings.
However, it’s worth bearing in mind that in the 2000-01 bursting of the tech bubble, and in the financial crisis of 2007-08, markets eventually looked through all the stimuli and the backstops and carried on falling.
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