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The end of analysis?

04 May 2020

Julian Howard of GAM Investments examines the potential that markets now have to avoid fundamentals, even in times of coronavirus.

  • We feel that markets have for some time now been largely ignoring fundamentals 
  • This remains the case even as coronavirus threatens a deep depression 
  • In our opinion, not all market sectors will benefit equally from perpetual policy response 

In the decade since the global financial crisis (GFC) to the end of January this year, global economic growth had been lacklustre, but the MSCI AC World equity index in local currency terms had breezily gained 170%. Similarly, analysis of market moves on the day the US releases its monthly non-farm payrolls jobs report reveals an ever-more muted market reaction function over the last 10 years. While bond yields have ‘rightly’ plunged, equity markets appeared to have de-coupled completely from fundamentals, a phenomenon that we feel merited closer inspection.

Then coronavirus hit. Markets saw waterfall slides worse than the first couple of weeks of the Wall Street Crash of 1929, and indeed every other market sell-off in the last century. Forecasts of economic meltdown and depression proliferated. US jobless claims had exceeded 26 million from early March to late April and, assuming the same numbers would translate into outright unemployment, it meant that America had, in the space of a few weeks, shed more jobs than those gained since the GFC. Surely now fundamentals would re-assert themselves?

Incredibly, markets turned around. From 23 March to 30 April, the same MSCI AC World index in local currency terms gained over 25%, recovering over half the fall that began on 19 February when the virus first hit markets. Even amid this emergency of all emergencies, risk assets were able to find a footing. For those investors who have always been taught that equities must ultimately follow economic growth and corporate earnings, coronavirus is merely the latest in a long line of similarly disconcerting episodes. The question is, why have equity markets become so impervious to fundamentals? And does it mean investors should simply hold a market index and stop thinking altogether even as economic meltdown occurs?

Ironically, the roots of today’s benign markets may lie in the prevailing state of economic stagnation we were already in before coronavirus, along with, we feel, the largely unimaginative policies that attempt to address it. The secular stagnation theory had undergone a similar narrative arc to climate change, with a small number of advocates, such as Summers, Kruger et al, banging the drum for years before the sheer weight of evidence finally led to a more widespread and possibly even begrudging acceptance. Ageing populations leading to shrinking workforces, inequality suppressing consumption and a lack of genuine innovation following the 1990s internet revolution are among the many convincing causes offered by way of explanation. 

Exacerbating the issue has been the lack of imaginative policy response, which has largely relied on ever-easier monetary policy by central banks around the world. This is because the sorts of policies that might actually address the fundamental causes of stagnation are politically fraught. Immigration, which might address shrinking workforces; smarter taxation on accumulated capital, rather than on labour, to address inequality; and a wholesale educational revolution, with a focus on so-called STEM subjects, to encourage innovation all simply require too much effort. Coronavirus is unlikely to help matters, as global co-operation falls to new lows amid a tawdry scramble for protective equipment, while rushed fiscal expansion is bent on supporting economic structures as they were, rather than as they could be in the future. It therefore remains for central banks around the world to try to pick up the slack, which they have done by further loosening monetary policy both conventionally (cutting interest rates) and unconventionally (quantitative easing). The resultant free money will not address stagnation, but for the time being it is likely to be the main policy response to the sizeable structural economic headwinds we face in the coming years.   

Chart 1: Perma-mergency: central banks keep up the response:

Source: From 31 Dec 2008 - 30 Apr 2020, Bloomberg; Big 4 central banks defined as: Fed, ECB, BoE, BoJ

Past performance is not an indicator of future performance and current or future trends.

For investors, this has the perverse effect of supporting stocks through two mechanisms: the equity risk premium and net present value. In terms of the former, low to negative interest rates have created a yawning gap – the equity risk premium – between equities offering high earnings yields (over 5% for the S&P 500 as at 30 April) versus the ‘safety’ of bonds offering effectively no income (0.6% for the 10-year US treasury as at 30 April). Market participants have given the phenomenon its own acronym, TINA, because There Is No Alternative for those looking for half-decent future returns based on yield-derived valuations. This assessment makes a broad case for risk assets as a whole, but there is a more nuanced support mechanism in place for long-term growth and technology stocks in the form of the net present value (NPV) effect. 

NPV is an accounting approach for valuing an asset based on its future revenue streams adjusted for prevailing discount rates. For those stocks whose earnings are less about the near term and more about future growth, today’s ultra-low to zero interest rates have a disproportionately beneficial effect, since they discount those future earnings back to a very high NPV. This benefits growth stocks generally and technology stocks in particular, while leaving ‘old world’ cyclical value sectors like financials, energy, materials and industrials facing an uncertain outlook in the likely event that money effectively remains free for a long time. 

Chart 2: Dispersion: coronavirus highlights stagnation’s winners and losers:

Source: From 31 Dec 2019 - 30 Apr 2020, Bloomberg

Past performance is not an indicator of future performance and current or future trends.

The unsettling conclusion of all this is that the long-term stagnation we have seen so far, and which coronavirus will only exacerbate, could possibly be favourable for many risk assets. Like learning that bicycle helmets or certain medical screening programmes do not save as many lives as previously thought, this is a stressful concept to grapple with because it is so counterintuitive. There will, of course, be times when coronavirus and its aftereffects rattle the markets in the short term. Some shocking economic data should be expected in the coming weeks and months, and the market will have bad days. But low discount rates mean, in our opinion, the accounting and financial fundamentals of the equity market matter more than the economic ones. It may also mean analysis has not completely died. 

While the market as a whole could be broadly supported by low interest rates, superior risk-adjusted returns are only likely to be achievable by focusing specifically on the sectors described above, as well as on other themes which can transcend low growth over time – for example, decarbonisation and emerging markets.

Finally, in another counterintuitive twist, it is possible the best long-term cure for stagnation might be more stagnation. Further years of low growth might eventually prompt a better policy mix than the one currently in place, with profound consequences for markets. Better then to keep analysing, just in case. 

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice