The Friday trading session in the US felt like something was finally giving. For days if not weeks the investing world has collectively been scratching their heads over how the stock market is coming back with a vengeance while a V-shaped recovery in the economy remains wishful thinking. After this historic March drop in the S&P index, prices have come roaring back, gaining 35% from the lows to Wednesday last week, almost touching the 200-day moving average under which the index had deeply submerged.
How does that work…? Consumption has cratered and so has consumer confidence. We have seen a record drop in services. Industrial production is on its knees. Jobless claims are at a record. This was not even caused by an economic crisis or a financial disequilibrium as we have learned to be the case in textbook economics, but unprecedentedly triggered by politicians, bureaucrats and scientists. They called for isolation, lockdown and social distancing. And what does the stock market do? It’s rallying…
Well, you can’t equate liquidity with solvency, or so they say. It is everyone’s own guesstimate, but the Fed will by now have added trillions of dollars to the system, to the tunes of 25-50% of GDP, and that is very obviously providing a liquidity boost that has its effect on investor sentiment. So, stocks going vertical must be anchored in that Fed boost, as it would be rooted in anticipation that a vaccine will be available earlier than experts say as well as a commensurate expectation for a rapid economic rebound.
In terms of liquidity and this set of expectations, the stars have undoubtedly been aligned for investor sentiment. However, can we reach for them much longer? Even if a vaccine could be developed and its production ramped up ahead of schedule, say even within this year, the economy is not likely to come back quickly. Q2 will certainly be a disaster, but Q3 and Q4 might not see that much an improvement, with travel etc being constrained. And this scenario wouldn’t even account for setbacks in the health crisis.
In other words, aggregate demand entailed by private consumption and business investments is likely to disappoint for longer than the markets are currently pricing in. Maybe we have witnessed a degree of normalisation and an interim end to the equity market exuberance during the Thursday and Friday session in NY. By any technical measure, we have been overbought, even the mother of all liquidity boosts by the Fed must eventually tire, and a turn in sentiment would appear logical.
We are all aware that the event we are living through is different from any other market stress scenarios we have ever witnessed in the past, but if one was ever to draw an analogy with the financial crisis, then we did observe a March-like equity sell-off in Q4 of 2008, by a whopping -40% for that matter, followed by a respectable bounce of around 25%, and subsequently, another drop of 30% through the end of Q1 in 2009 before the bottom was finally reached.
Another reason for suspicion about the equity move is the Treasury market’s behaviour. Ever since the unwinding volatility subsided at the end of March, 10-year yields have flat-lined at the current 60bp level. To be sure, the Fed’s asset purchases have to be taken into consideration, and there are no more real markets as we had grown up to know them, but why would those yields not rise in light of the equity market soaring and painting a picture of anticipated business improvements and economic recoveries alike.
Because it ain’t so, or at least that is what Treasuries are telling us. They are predicting a much worse scenario going forward. If bonds have it right, then 10-year yields are probably not at their lowest yet, and we are likely to observe further attempts for bonds to rally and for the yield to converge towards zero. If in this case the Fed were to want to start managing the rates curve more proactively, much as the BoJ has done, then the short-end might well dip into negative territory.
All this kind of implies that the stock market is in danger of being divorced from reality, for very much the reason of the Fed having giving it a liquidity boost. This is great for traders, as they can make money on massive swings in the indices. But what we need to focus on here is who is going to prevail over not just the coming week but the coming months. And there we might find that the Fed bazooka commands a half-life of less than we expect and the weight of the economic misery will have the upper hand.
Never go against the Fed… we are all more or less painfully aware of this notion. But the investing world may soon find out that this is not an eternally valid proposition. A second leg down of 30% like in Q1 of 2009 would land the S&P at 2,000 points. Worth keeping in mind.
