This Is Why the Financial Markets Have Rallied While the Economy Is in the Tank
There’s a large disconnect between the carnage in the economy — with sectors such as restaurants and retail largely shut down — and the strong rebound in the stock and corporate bond markets. This doesn’t even include the terrible personal toll that the pandemic has inflicted on so many people.
Through almost 50 years’ worth of data, we’ve never seen weekly unemployment claims like we did in May and June. Even though the count of claims came down once the initial shock passed, it was still much higher than at any time, including the Great Recession. All the while, the personal savings rate is through the roof and unlike anything we’ve seen going back to the late 1950s. This is a good-news/bad-news situation. The good news is that folks have a lot of money in the bank to spend, which could help the economy rebound quickly. The bad news is that the personal savings rate signals that people are worried about the future, in particular about their economic security.
The current environment has confounded economists and market forecasters. There have been headlines such as “The V-Shaped Recovery Has Died of Coronavirus” followed a few days later by “Hail the Dawn of a V-Shaped Recovery.” Gross domestic product quarterly growth forecasts have never been so dispersed.
The Gap between Main Street and Wall Street
While it’s true that “the stock market isn’t the economy,” they are related, at least in the long run. The stock market may be more volatile than the growth rate for GDP, but both typically move in the same direction. There’s an old joke that the stock market has correctly predicted nine out of the last five recessions. But it’s also undeniable that, over the long term, the stock market won’t grow unless the economy does.
There is a stronger and more direct connection between the economy and the corporate bond market, specifically when it comes to credit spreads, which for given corporate bonds are the extra yields investors receive versus the yields on a risk-free alternative like a Treasury bond. For example, if a Treasury bond is yielding 2% and a corporate bond is yielding 5%, those extra 3 percentage points are the credit spread. It compensates investors for all the nasty things that can happen when owning a corporate bond compared with a Treasury bond, the biggest of which, especially in high yield, is default. Credit spreads closely track what’s happening in the economy, or perceptions of what’s happening in the economy, with spreads going up when the economy weakens.
So why is the market doing well?
There are just not many attractive places for investors to place their money. The dividend yield on the S&P 500 at one point was over 2%, which was actually higher than on many corporate and Treasury bonds.
For indexed fund managers, there’s a real fear of missing out on the rally. If managers were bearish on the market during the height of the pandemic panic, and had money in cash or in safer investments, once the market started to rally, they had to get back in, or else they’d be underperforming. This leads to a swing momentum effect that pushes the market up higher and faster than it might otherwise, due to this fear of missing out. The same goes for individual investors, but obviously institutional managers are the ones who have serious money to invest.
Another point is that there’s a strong sense, especially in an election year, that the political and governmental support for valuations puts a floor under the market and makes people confident to get back in. This hasn’t been wrong, of course.
On a more technical level, many big investors had used options to generate income. In particular, they bet on low volatility. So when the market began to decline and price volatility picked up, investor position-covering drove it down further. But once it bottomed out, the same strategies increased momentum on the upside.
The composition of the market is another factor. In particular, there’s a high degree of concentration in the market on an industry basis. And over the past 25 years, this has gotten more intense. The argument is that listed firms tend to be larger firms, and as an industry becomes more concentrated, the listed firms have more scope to post price increases because of concentration. The process is accelerated during recessions, when smaller firms get winnowed out. The result is a virtuous circle (in terms of market valuations) that helps the listed firms do even better and pushes prices up.
In the same vein, the fact that most equity indices are constructed on a market cap-weighted basis is also important, since most big companies have done really well in the recent downturn. For example, the five largest companies in the S&P 500 index now make up over 20% of the benchmark. Their strong performances have been a major contributor to its rise, even though the majority of the constituent stocks were falling in value.
Of course, we know markets are forward-looking. Their sharp rebound since March implies that investors believe in a V-shaped recovery, meaning that the shock will be short and sharp and then the economy will bounce back quickly. It remains to be seen if this will be the case.
However, a positive factor is that going into the COVID-induced shutdown earlier in the year, the economy and the banking system were both in good shape. This is important because classically when there’s recession, there’s some kind of imbalance in the economy or financial system that needs to be worked off and corrected, like excess valuation and investments in housing during the Great Recession. In past downturns this has proved to be a slow and painful process, and one that needed to be completed before the economy could return to growth.
Stock Market Performance Doesn’t Impact Companies’ Operations
One of the key reasons the stock market doesn’t matter nearly as much as the corporate bond market is that contrary to what many believe, the stock market, on a net basis, doesn’t supply financing to companies. Instead, it does the opposite, returning much more money to investors in the form of dividend payments and stock buybacks than it takes from them in the form of share offerings. This creates a disconnect between the performance of the market and what companies do day to day. Thus, when the stock market sells off, it really doesn’t affect companies’ operations. It might hurt the compensation packages of senior managers, but that’s a different matter.
By contrast, companies are constantly selling bonds. So when the market shuts down, it has an immediate negative impact on a lot of entities.
When the corporate bond market last declined sharply, in 2016, it reflected a fall in the price of oil, which hurt energy companies. They made up about only 10% or 12% of the high-yield market, and less for investment grade. The economy otherwise was in pretty good shape. Now we have a situation where the economy is in poor shape, but credit spreads are a lot lower. What’s causing this? The main reason is government support, specifically the Fed’s support for the bond markets. There’s nothing like that in the equity market. The Fed really buys very few bonds, but the idea is that it has the market’s back, and that’s powerful. There’s an expression that “You can’t go wrong by buying what the Fed is buying,” or “Don’t fight the Fed.”
Recently, corporate bond markets have rallied, but investors are not being indiscriminate — they are buying safer bonds more aggressively than riskier bonds, unlike what has happened before. This means they’ve got the idea that the Fed is supplying a lot of liquidity to the market by its implicit support, which removes one source of risk. But the Fed cannot keep things propped up forever. If these companies run out of cash, they’re going to default regardless of what the Fed does. That’s why spreads are rallying less with lower-rated issuers.
The real risk for the economy overall is that if defaults rise and stay elevated, then credit spreads will increase, and liquidity will decline. That alone will probably cause an increase in defaults, and that would trigger an economic slowdown as companies go bust, can’t pay their workers, and so on. This is what the Fed has managed to avoid so far by providing liquidity, and that’s a good thing. It’s worked well, especially since it hasn’t had to actually pay out much money in terms of how many bonds it’s bought. But sooner or later, if the economy stays weak for a long time, gravity will assert itself. These firms will start to default, and then we’re really off to the races.
The bad news with this downturn is that it’s been caused by a public health problem, and the COVID-19 pandemic is far from being under control. Consumer spending is around 70% of the U.S. economy. As long as the pandemic continues, it’ll hurt consumer confidence. That’ll further depress economic activity and increase unemployment and drive up bankruptcies. Until we can get the pandemic under control, we’ll limp along. We’ll have subpar economic performance, and the equity and bond markets will, increasingly, look like they’ve taken too positive a view of things.
About David Munves
David Munves, CFA, is president of DWM Consulting Services LLC, which provides strategic advice and sales acceleration tools to companies serving the credit risk and capital markets. His expertise is in credit analytical, ratings-related AI, relative value, and capital markets products. Previously, David was Head of Sales and Marketing for SFJ Technologies LLC and is currently a senior advisor to the company focusing on providing go-to-market and sales development plans. Prior to that he was Managing Director of Moody’s Analytics, reporting to the head of Moody’s largest division (Content), where he was responsible for product development and sales support for a range of products based on market data and credit ratings inputs.
This article is adapted from the July 7, 2020, webcast “Main Street vs. Wall Street: Explaining the Gap between the Financial Markets and the Economy.” If you would like access to this teleconference or would like to speak with David Munves, or any of our more than 700,000 experts, contact us.