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Posted by Andrew & Nada on 11th August 2020
Stock market disconnect from world economy leaves investors guessing

The impact of COVID-19 has left the stock market out of alignment with the world’s real economy. In fact it’s broken, says Nada Kakabadse, Professor of Policy, Governance and Ethics at Henley Business School, and Dr Kirill Perchanok, investor and author.

The relationship between stock and bond returns is one of the fundamental building blocks of asset management strategy. However, the nature of their interaction is not always constant.

The stock-bond correlation is positive most of the time. However, there are three significant periods in recent history when this relationship has experienced a negative correlation, namely the early 1930s, 1960 and most of the time since the late 1990s.

Disparities occurring around these dates can be categorised as:

  • When the relationship between bond prices to stock prices is positive – for example falling bond yields tend to reduce equity discount rates
  • When the relationship from stock to bond prices is negative or decoupled – equity weaknesses can prompt monetary policy easing and a bond market rally

The correlation between bond and stock can be influenced by a perplexing number of variables, summarised by the expression that ‘good news for the economy can be good news for bonds.’

However, this doesn’t always hold true. Stock–bond correlation tends to hit its lowest point in two scenarios: firstly when inflation and growth are both low – in other words deflationary recession as was the case in 1932; and secondly when equities are weak and volatile, as demonstrated by ‘flight to quality’ episodes.

Sometimes, both stocks and bonds can go up in value at the same time. This happens when there is too much money, or liquidity, chasing too few investments. It happens at the top of the market. It can occur when some investors are too optimistic, and others are overly pessimistic. There are also times when stocks and bonds simultaneously fall. This is when investors panic and sell everything. During these periods gold prices often rise.

The stocks and bonds relationship is further influenced by dynamics in the markets. Stocks clearly do well when the economy is booming. This happens when consumers are making more purchases, companies receive higher earnings thanks to increased demand, and investors feel confident.

One of the best ways to beat inflation is to sell bonds and buy stocks when the economy is doing well. When the economy slows, consumers buy less, corporate profits fall, and stock prices decline. This is when investors prefer the regular interest payments guaranteed by bonds.

Interest payments stay the same for the life of a loan, while a bond’s value changes over time. Large price declines trigger similarly large outflows. Bond prices - loans to a corporation or government, and stocks - shares of ownership in a company, are generally correlated to one another.

When bond prices begin to fall, stocks will eventually follow suit on a downward trajectory as well. As borrowing becomes more expensive and the cost of doing business rises due to inflation, it is reasonable to assume that companies (stocks) will not do as well.

Bonds affect the stock market by competing with stocks for investors’ dollars. Bonds are safer than stocks, but they offer a lower return. As a result, when stocks go up in value, bonds go down.

In 2008 the financial sector experienced unprecedented panic resulting from and in an extreme contraction of the economy around the globe. In an attempt to counter this governments and leading nation monetary authorities introduced aggressive fiscal and non-fiscal stimulus measures, supported by the coordinated actions of central banks. Since this time the financial markets have entered a low-interest rates and abundant liquidity environment.

Of particular note is that most central banks have aggressively reduced their base rates. For example, the US Fed reduced its rate to 0.5%, ECB – to 1% and the Bank of England to 0.5%. Similar policy decisions have been enacted by China, Brazil, India, Australia and tens of other nations.

The US Fed went even further and introduced a non-conventional measure known as Quantitative Easing (QE). Later on, all major world Central Banks followed suit and introduced their equivalents of QE. Some Central Banks, including ECB, SNB, and Bank of Japan extended upon this approach by intervening in financial markets and implementing negative interest rates.

As a result, the stock market no longer reflects a familiar outlook that is genuinely aligned with the real economy. This is irrespective of whether stocks are growing due to the excessive cash injections being made by governments, stock buy-backs, and constant stocks short squeezing. The inescapable conclusion is that the stock market is broken.

Not only this but the bond market is now similarly shattered. Approximately 13 trillion USD bonds issued by different governments worldwide had a negative yield at the end of 2019.

In early 2020 the world faced an unforeseen event in the form of the COVID-19 pandemic and, as a result of policymakers’ responses, economies around the globe came to a temporary halt. The reaction of all major central banks was very similar to that of 2008 – a mass reduction in interest rates (FED) and associated quantitative easing.

But this time the monetary response has been far more aggressive. For example, the FED added approximately three trillion dollars to its balance sheet during a very short time span of three months. Additionally, it introduced a new measure to buy corporate bonds through newly created vehicles, something almost unthinkable before COVID-19.

As a result of these measures there is currently even more negative territory debt and stocks are almost back at pre-pandemic levels. However, the stock market is not the economy. The gap between Wall Street (USA), the City (UK) and ‘main street’ appears to be very wide, with the latter continuing to suffer.

This all leaves us with the question: how should investors make their investment decisions in the current circumstances? What should they based their judgement on? Are there any analysis tools left for investors other than reviewing and predicting front-running central banks’ actions?

The major long-term problem is an absence of natural price discovery on the financial markets. In the case of broken stocks and bonds it remains to be seen if there is still any connection or mutual influence between both investment classes, which used to be strongly linked in the past, but might be already broken as well?

Existing monetary policies are unlikely to change in the near future amid a prolonged period of zero to negative interest rates.

However, at some point financial authorities and, in particular, the FED will attempt to implement ‘yield curve control’ by introducing bond-buying programs, combined with stock-purchases by central banks around the globe.

These actions will further damage natural price discovery on the financial markets, leading to high inflation and aggressive attempts by authorities to ‘leak’ inflation from the markets into the ‘real economy,’ which may or may not be successful.

 

This article first appeared on https://henleybschool.blog/2020/08/06/has-stock-market-disconnect-from-world-economy-left-investors-guessing/

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