Where to, Mr. Market? An Economic Outlook by Dr. Constantin Gurdgiev
Driven by the combination of the expected positive fundamentals (namely, forecasts for a robust V-shaped recovery in the U.S.followed by fast-paced recoveries in the emerging markets) and by unprecedented monetary policy developments through 2022, global equities have entered a new bull market phase. Left unperturbed, investors’ expectations are likely to drive markets higher in the medium term, irrespective of the underlying individual assets’ fundamentals. Put differently, we are in the hype period of asset markets valuations, when corporate finance, as a discipline, matters none to the bullish buyers.
This economic outlook is provided by Dr Constantin Gurdgiev who is the Adjunct Assistant Professor of Finance with Trinity College, Dublin and serves as a co-founder and a Director of the Irish Mortgage Holders Organisation Ltd and a co-founder of iCare Housing Solutions, two non-profit organisations working with the issues of financial empowerment.
COVID-19 pandemic has triggered a flood of mon-and-pop day traders and long-only investors into the markets. This process began in late April and continued through May. Stuck at home, and overwhelmed by the news flows of the rapid bounce in the financial markets, the punters have rushed to buy up everything and anything they can get their hands on, from advanced economies core markets ETFs to bankruptcy-declaring airlines and car rental companies’ stocks. Meanwhile, institutional investors are awash with liquidity at extremely low cost, thanks to the Fed and all other
Central Bank pumping trillions of dollars into the global financial system.
The caution of February-March has been thrown to the wind.
BOOMING RETURNS AND THE NEW BULL MARKET
S&P 500 total return index is up 11.27% in the last 3 months, while the broader S&P 900 index has gained 11.19%. More narrowly-based larger companies S&P100 has returned 12.85%. Year-on-year, the three indices are up 12.72%, 11.84% and 17.07%, respectively.
As these numbers confirm, and the chart below illustrates, we are witnessing increasing concentration in returns at the top of the equities distribution by company size. Larger corporates are being priced up more aggressively than smaller, more growth-oriented firms. Which indicates that investors are neither looking for value, nor for future growth potential, despite the markets being driven by a massive drop in risk aversion. This goes against the dominant asset valuation theories and practice of finance, collapsing risk premium in the higher growth ranges, and increasing returns in lower growth assets.
Related to this phenomena is another notable feature of the new bull market: the rebound in investors’ willingness to take on leverage risk. Expectations of future buybacks, debt gearing and dividends payouts – the factors that commanded a massive discount on the downside of the markets back in March – are all back in favour. Chart 2 next shows that the premium on S&P Buybacks Index has swung from severely negative (-2.4% average for mid-March through mid-May), to positive (averaging 3.83% since the start of June).
In other words, investors are reverting to the pre-COVID-19 modus operandi. In the age of lower long-term economic growth expectations underpinned by the secular stagnation hypothesis of ageing demographics, cheap debt and ample liquidity being supplied by the Central Banks take precedence over prudent management of company balance sheet and cash
flows.
This willingness of investors to take on higher liquidity, leverage and concentration risks and carry long equites with weaker financial fundamentals is further exemplified by the recent developments in the corporate credit markets. Chart 3 below shows the recovery, from recent COVID-19 driven lows, in the corporate bond indices for prime investment grade (AAA) rated debt, investment grade bonds (BBB) and junk bonds (CCC and lower ratings).
Off-March 2020 lows, AAA-rated debt is up 12.17%, BBB-rated debt is up 14.89% and junk bonds are up 18.09%. Given that corporate bankruptcies have increased 48% in May 2020, compared to May 2019, having previously risen 27% in April, investors bidding up junk-rated debt clearly signals the lack of markets concern for solvency and prevailing optimism that current excess liquidity conditions in the markets will persist into the medium-term future.
FOLLOWING THE MONEY
This pivot is rational in the short run.
U.S. Federal Reserve has been injecting liquidity into fiscal and financial assets at a maddening pace since the start of the COVID-19 pandemic. Since the beginning of March through the end of May, Fed has pumped USD1.06 trillion into M1 money supply and USD2.52 trillion into M2 money supply. M1 includes funds that are readily accessible for spending, such as currency held outside the monetary-financial system and demand deposits. M2 includes a broader set of financial assets held principally by households, namely M1 plus savings deposits, small-denomination time deposits, and
balances in retail money market mutual funds. However, over the same period of time, MZM – Money Zero Maturity stock went up by USD 3.69 trillion. MZM is defined as M2 less small time deposits plus institutional money funds, and the gap between M1 and MZM effectively measures the
amount of money available to institutional investors, or the Wall Street. This amount rose USD2.63 trillion during the COVID-19 pandemic and USD3.52 trillion year-on-year.
Chart 4 above highlights the amount of funding pumped by the U.S. Fed into the financial system in the U.S. since the start of the current crisis, as well as liquidity supplied in the Global Financial Crisis and during smaller money markets blowout of 2019.
Not surprisingly, Fed policies, aided and supported by other Central Banks, are spilling into a bull market run globally. As of the time of writing, three quarters of countries tracked in the MSCI World index are up more than 20 percent on theirCOVID-19 lows. This is the highest level since early 2010.
MSCI All Countries World Index itself is up 40% off the March 23 lows.
Global monetary policy interventions have been unprecedented, not only in volume terms, but also in breadth of their reach. Interest rates and asset purchases policy responses have been swift (from early March through May), coordinated globally (with 93 Central Banks worldwide having engaged in monetary easing of one type or the other), and closely coordinated with fiscal policy stimuli. They also targeted idiosyncratic cashflow and liquidity bottlenecks created by the COVID-19 crisis, providing support for companies cashflows and banks’ balance sheets and capital buffers. Equally important, all major Central Banks dramatically expanded the mix of traditional and nontraditional policy tools. Last, but not least, the Central Banks most recent guidance – from Bank of Japan to Peoples Bank of China, from the ECB to the U.S. Fed, from the Bank of Canada to the Bank of England – references 2022 as the first potential stop for the monetary policy revision.
In other words, the financial markets party unleashed by COVID-19 is likely to persist in the medium term (the next 12 months or longer).
The key transmission channels from the monetary policy to the Wall Street valuations are forward-looking and tailwind-supported. On the tail winds, BOJ, ECB and Fed alone have injected some USD 5 trillion worth of funds into financial assets, ranging from sovereign bonds to mortgages-backed securities (MBS). This translates to an average monthly money supply increases of more than USD 600 billion. Prior to COVID-19 pandemic onset and October 2019 money markets panic, the same central banks were cutting global supply of liquidity by ca USD 200 billion per month.
MEDIUM TERM VS THE LONG RUN
In the longer run, however, the issue of what exactly the investors buying and at what valuations will have to be addressed, once the monetary policy starts shifting from aggressive intervention to neutral. As the friends of mine at the GlobalMacroMonitor (GMM: https://global-macro-monitor.
com/2020/06/10/why-so-few-bears-own-park-avenue-apartments/) wrote
in a recent research note: “There is a rapidly growing group of people who think the laws of economics have been suspended. That is there are no constraints on financial resources.” The GMM folks calculated that the average starting point for each historical bull market between 1974 and 2009 was at the U.S. equity market capitalization just over 53 percent of the country GDP. On March 23, 2020, the date of the launch of the new bull market, that ratio was 105.3 percent and by end of last week, it was heading toward 170 percent mark, or 25 percentage points above the peak of the dot.com bubble.
Which brings us to the point of advice: investors will do well to carefully take profits off the table and maintain current equities exposures at a fixed level as the current medium-term bull run progresses through the rest of 2020
Most likely, the earliest when the head winds of the future monetary policy reversals should start appearing on the horizon will be Q2 2021. At this stage, investors should start unwinding their long-only positions and shifting into safe haven and tail risk hedging assets, such as counter-cyclical and high quality corporate stocks, select Government bonds, gold and cash. The trigger for the forthcoming markets sell-offs, most likely will be emerging markets’ assets and secondary quality-rated Government bonds in the Eurozone. However, a spike in the U.S Treasuries can predate these
and complicate traditional hedging strategies.
Safe sailing, until then.