Unmasking The Financial Markets

Unmasking The Financial Markets


The economic carnage inflicted by the fight against the coronavirus pandemic has been real—and horrific. Over 40 million Americans have filed for jobless claims since mid-March, when the U.S. economy went into lockdown mode to slow the spread of the virus. According to the latest government stats, there are 21 million currently unemployed and a jobless rate of nearly 14%. The investment markets (and the President) cheered this report as it is a slight decline from the previous high in April, even though there is a lot of uncertainty surrounding the numbers, and they are subject to revision up to a year later. However, if the additional 10 million folks who are working part time, but want to work full time (if they could get a job), and the 9 million people who are considered “not in the labor force” by the government bean counters (but still WANT a job) were included in the calculation, the total unemployment rate would be 25%!

After shrinking 4.8% in the first quarter, and despite most States seeing some level of re-opening in late May, some economists are forecasting that U.S. GDP could contract by a staggering 40% in the April-to-June timeframe. Regardless what the number turns out to be, there is no doubt that America is smack-dab in the middle of a severe recession, unrivaled in magnitude in the past 80 years.

But as anyone that has at least 50% of their portfolio invested in an equity allocation, and has looked at their account statement for May will see, the equity market has staged a strong rebound from the March/April lows in spite of the current economic reality. What’s the deal?

Why has the stock market roared back onto the highway so quickly if the economy is still stuck in the mud?

Primarily it is because Markets, first and foremost, are forward-looking vehicles. They focus on the future, not the present or the past. And right now, markets are peering around the corner and they believe they see things that spell better days ahead. Whether the market is correct in that belief or not will be determined over the course of the future weeks and months. Right now, I believe the market has rebounded because of primarily three factors:


The realization of “less bad” news, and the expectation of future “good” news

Often it isn’t necessary for news to actually get “good” for markets to respond positively. The news simply has to get “less bad” and the market will begin to price in the expectation of recovery.

The avalanche of bleak economic data that’s roiled the world over the past few months is a direct result of the necessary government-mandated economic lockdowns that spread from east to west in February and March. When businesses and factories are shut down, jobs are lost. Consumer spending plummets. An economy brought to a standstill is going to look just as bad on paper as it does in real life. And that’s exactly what happened.

But, importantly, the global economy is no longer at rock bottom. Starting in April, European countries began easing their lockdown restrictions and slowly reopening in piecemeal fashion. This trend spread to the U.S. in May, with all 50 U.S. states now in the process of partially reopening as well.

As the economy begins to rebound, so too will the economic data. As more businesses reopen, the pace of job losses will continue to slow. Consumer confidence should also slowly tick up. A slightly more confident consumer will be likely to spend a bit more—granted, not to anywhere near pre-pandemic levels, but certainly to a level higher than was observed at the peak of the lockdown. Simply put, the more the economy reopens, the more the overall data will improve. And it’s this expectation of better economic data that is helping to propel markets forward. Of course, the important caveat to the continued positive effect of this “less bad news” thesis is there is not a resurgence in the virus infection rates across the country.


Unprecedented fiscal and monetary stimulus

The second factor in markets’ continued upward climb can be attributed to the speed and vast amounts of fiscal and monetary stimulus injected into the global economy since March. The combination of fiscal and monetary stimulus already enacted, and announced but yet to be put in place by the Federal government and Federal Reserve amount to almost 25% of America’s annual GDP. That’s a staggeringly large number in scope. And the U.S. is not alone. Australia and Canada have also passed similar, though somewhat smaller relief packages, while Japan takes the cake with a package consisting of a whopping 40% of its yearly GDP!

Collectively, all of this aggressive fiscal and monetary support is like throwing vast amounts of fuel on a sputtering fire. As lockdown restrictions ease and more businesses reopen, that fire—the global economy—will rekindle. Markets, for their part, are betting that the fire will be able to sustain itself for a decent length of time. One possible negative reaction to this vast stimulus could be the igniting of significant global inflation. As a precaution to that possibility we have added some inflation protection to most client portfolios in the form of gold and Treasury Inflation Protected Securities.


Low interest rates

The third factor driving the equity market’s recovery are today’s really low interest rates. Why? Well, two reasons. Firstly, they remove the attractiveness of bonds as an investment alternative to stocks. Secondly, they make stock valuations “appear” to be less inflated. Recall that stocks are ultimately priced on the net present value of a company’s future earnings. With this in mind, there are two ways to increase the net present value of future earnings: by actually achieving higher earnings growth – which is tough in today’s economy – or via low interest rates used to “discount” the future earnings.

If, for example, the 10-year U.S. Treasury yield is 62 basis points, and this is used as a barometer for the discount rate of equities, then a dollar of earnings five years from now is worth almost as much as a dollar today—approximately 94 cents. Such an extremely low discount rate would almost entirely compensate for any disruption in short-term earnings, as

a company’s required earnings growth over the same time period wouldn’t need to be as impressive. The bulk of the increase in net present value would come from the discount rate.

In other words, a dollar of earnings for a company five years down the road is worth a lot in today’s dollars. And if you have strong confidence in the earnings of a company five years from now, you’re going to be willing to pay more for that company’s stock now.

In summary, though the effects of the mandatory shutdown of most of the global economy in order to stem the spread of the virus have been devastating, the news is becoming less bad as the countries around the world take steps to restart growth. If the news continues to improve, and there doesn’t appear to be a sharp resurgence of infection, this combined with the effect of stimulus and low rates could propel further upside for the equity markets. But it remains a very uncertain time and prudence dictates the wise move is to remain conservatively allocated and focus on owning good quality assets for the long term.

About the Author

Randy has more than 15 years of experience managing financial assets for individuals, retirement plans and businesses. Randy joined YHB | Wealth Advisors in January of 2018 and serves as the Director of Wealth Management. Prior to entering the professional wealth management field, he enjoyed building entrepreneurial business ventures from start-up to eventual sale and providing accounting services for public and private firms.