The disconnect between the stock market and the real economy, particularly in the US, has been evident throughout the coronavirus pandemic. Between February 19th and March 23rd, the S&P 500 benchmark lost a third of its value, with investors selling shares as the COVID-19 pandemic escalated in Asia and Europe. The same index has soared 52% since the news that the Federal Reserve would buy corporate bonds to help firms finance their debt. This shifted investor sentiment from panic to optimism and market confidence increased as a result of both the monetary stimulus from the Fed and the fiscal stimulus from Congress. This stock market rally occurred, and is continuing to persist, despite the US economy contracting by the greatest percentage in post-war history in the second quarter of 2020.
The US economy
The second quarter of 2020 saw the US economy shrink at an annualised rate of 32.9%, reflecting the sharp slump in personal spending, exports, and business investment. The consensus expectation of last week’s initial jobless claims was 920,000, with economists having forecasted an improving trend for employment. However, the actual figures showed a rise in the initial jobless claims to 1.1 million from the previous week’s total of 971,000, showing a reverse in the two-week trend of improvement. This “negative surprise” in the data accelerated the rise in price of US treasury 10-year bonds, with increased buying pressure on what are considered the “safest investments on Earth”. As investors purchased more 10-year US treasury bonds, the upward pressure on bond prices drove the yield down by 0.03 percentage points to 0.648%. Investors crowding into safe havens have been a key feature in the coronavirus market environment, with commodities such as gold soaring to an all-time high and silver reaching a seven-year high. The recovery of the US economy is dependent on multiple factors, with a potential second wave of infections the major factor that will affect the duration and scale of the US recession. The trajectory of the real economy in the short-term is also dependent on a fiscal stimulus from the US Congress, with Republicans and Democrats currently at an impasse as to the size and duration of a new fiscal relief package.
Federal Reserve response
Emergency measures were adopted by the Fed early in the COVID-19 crisis when it appeared as if the credit markets may freeze. The Fed cut interest rates to zero, expanded their balance sheet through open-ended government debt purchases, and used emergency lending to prop up markets. The Fed committed to purchasing assets which included corporate debt and high-yield junk bonds (those with a credit rating of BB or lower) on an unprecedented scale. This has meant even the riskiest bonds in the corporate credit markets have rebounded due to the Fed’s intervention, with US companies issuing $560bn worth of bonds over 6 weeks between April and May. The fact that the real economy is struggling in the ongoing global recession means that low government bond yields are making stocks more appealing as an alternative for investors. Therefore, the extra liquidity in the financial markets, provided by the Fed, has made the earnings yield on equities more attractive in comparison to government bond yields and provides this link between the intervention of the Federal Reserve and the rallying stock market.
The divide between the rallying stock market and the struggling real economy is clear to see. What is not so clear is the extent to which divisions are created, or worsened, between businesses. The COVID-19 crisis has exacerbated the inequalities that pre-existed in the US between smaller businesses and large, blue-chip corporations. The monetary stimulus from the Fed, in the form of buying up corporate bonds in debt capital markets, has arguably aided the shares of large corporate firms, particularly those with access to the capital markets. The strength of their balance sheets along with higher profit margins have enabled larger companies to deal with the challenges of the COVID-induced recession more easily than smaller US businesses.
This gulf is demonstrated by the performance of the benchmark S&P 500 in comparison to the Russell 2000 Index. The Russell 2000 Index is a market-cap weighted index which is composed of 2,000 of the smallest-cap US companies in the Russell 3000 Index — the largest 3,000 US companies by market capitalisation. Although the S&P 500 has seen a 34% aggregate drop in earnings to $233bn, the index is now 4.6% above where it started the year, with investors crowding into tech stocks in particular. On the other hand, the companies which form the Russell 2000 Index have seen an aggregate loss of $1.1bn, compared to profits of almost $18bn a year earlier, and the index now resides 5.1% lower than it did at the start of 2020.
The composition of both indices is crucial in explaining this disparity, as the Russell 2000 Index is weighted heavily towards less profitable sectors such as healthcare, financials, and industrials, with tech stocks composing just 14% of the index. According to Craig Burelle, an analyst at asset manager Loomis Sayles, the stocks which form the Russell 2000 Index are “highly exposed to cyclical sectors” and will hence perform comparatively worse than the S&P 500 during a recession. In contrast, 27% of the S&P 500 is comprised of tech stocks, including the FAANG stocks of Facebook, Apple, Amazon, Netflix, and Alphabet (Google’s parent company), as well as Microsoft. Many investors have crowded into this sector due to the strength of big tech conglomerate’s balance sheets, and the increasing reliance on technology that businesses now face.
The disconnect between the stock market and the real economy is one which many do not foresee continuing into the future, with the stock market usually following economic output. Therefore, many believe that a reconciliation between the stock market and the real economy is inevitable and the magnitude and impact of such a correction will ultimately depend on the timescale this follows. A Bank of America survey concluded that an increasing proportion of investors think that many key asset classes are now “overvalued”, with US stocks now priced at more than 22 times expected earnings over the next year, according to Factset. This is a level not seen since the dotcom bubble burst two decades ago.
With the US fighting to get the rate of infections under control, the real economy is extremely dependent on government policy and how quickly the US can either discover a vaccine or operate effectively as a “90% economy”. The path the markets take in the short- to medium-term could depend on the upcoming Jackson Hole Economic Symposium, viewed as a platform for significant policy announcements, and the Fed’s September meeting. The outcome of such proceedings is likely to impact investor sentiment about the markets and play an important role in the future gap between the stock market and the economy.