Are the stock markets very disconnected from the Economy? I think it is. We even had a headline to that effect in one of our past articles, but we didn’t develop much on that. Think this is a good time to have that discussion.
As we all know, the Fed stepped up to the situation very swiftly and drastically in much bigger ways than we could imagine, to counter the fall in asset prices and economic conditions. They dropped interest rates to zero in a jiffy, mind you, that decision was taken on a Sunday not at its usual FOMC meetings. They pumped in three trillion dollars in less than three months which they had not done in the last 8 years. The balance sheet has bloated to 7 trillion dollars and is expected to rise more.
Let’s take a small peek at what was the state of affairs before the pandemic hit us. All major economic indicators were contracting. GDP, capital spending, productivity, corporate profits, construction spending all were showing recessionary tendencies. No doubt, unemployment rate was at a 50 year low. It even tested 3.5% which is below Fed’s idea of full employment.
So, what kept the asset markets and economy up? It was consumer spending and financial engineering. Mainly share buybacks. Money never went into capital spending as it should have. Share counts went down to a 20 year low.
US is a very service-based economy and normally it constitutes 70% of the GDP but in 2019 it was around 90%. If you analyse more deeply around 80% of this growth in GDP was through non- essentials. What do I mean by that? Entertainments, leisure, theme parks, travel, restaurants etc. Low skilled, less educated, and low paid jobs. That is why despite having the lowest unemployment rate of all times, US did not have any wage growth.
So, when the pandemic hit us, these businesses got hit the most and now when the economy opens up, they will be the hardest to recover. Firstly, social distancing is anti-growth. The government has reconfirmed that they will not go into an economic shut down again. Probably that may the right thing to do. But people will. If the second wave of coronavirus virus gets out of control, businesses are not going to reopen. Capital spending will not take place or will be to a minimum. Mostly to meet the requirements of pandemic regulations. As it is, leverage was already high in the corporate sector before all this happened.
The very unfortunate thing and unique to this situation is that for all the largesse that the Fed and Treasury are doing, they will not get the desired results. The Fed cannot create income nor employment. They can only create conditions. It is the corporations and small businesses who can do that. The Fed must have moved from a risk-free interest rate to a no interest rate position but what is the use. Japan is a great example.
Consumer spending habits will change drastically. It already has. Saving rate has risen to 33%. Not that it will stay high at these levels. Households were not prepared for this. The pandemic was a wake-up call to many. So, it is more likely households will use the government handouts to repair their balance sheets and save more cash. Of course, there will be the odd millennials who will use it as monopoly money to punt the markets. We will hear about their fate soon.
The authorities are caught between a rock and a hard place. When something similar happened in the 1930’s, in terms of the markets the then President FDR created jobs through infrastructure spending. The Hoover dam and Golden Gate Bridge in SF are results of that. The current position is to pay people for not to work. How long can this continue?
One thing for sure the Fed will play a major role in all aspects of the economy and to a lesser extent the dollar will too. The dynamics of deflation, disinflation, inflation, and stagflation will become major talking points. I think the end result will be stagflation. That is totally a subject on its own, we will discuss another time. As Voltaire said in 1729, paper has to return to its intrinsic value which is zero.
Finally, the stock markets will gravitate towards the real economy. The liquidity driven prices will find an equilibrium. Equities will still be attractive, but one has to look for those ones that is adapting to the changing conditions.
It will be a different story if a vaccine is found or if an effective treatment is found to eradicate the virus. The delay in that process will determine the future of many businesses.
Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund.
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