Clients often ask us whether we perceive a disconnect between markets and the real economy.
It’s an understandable question. At the same time as US equities scale new heights, the economy’s foundations seem weak. US initial jobless claims have remained around the one million mark for the past two weeks, for example, while some recent sentiment surveys in Europe have disappointed too.
Yet, although we expect only slow economic growth and persistently high unemployment into 2021, we don’t believe the apparent divergence between the state of the economy and the exuberance of financial markets is completely irrational. I would highlight four overlapping explanations:
1. The economic distress is concentrated in the sectors most affected by social distancing, which are mainly small non-listed businesses.
2. Central banks have slashed rates and restarted asset purchases while governments embarked on massive fiscal stimulus. This has pushed interest rates even further down; almost a quarter of the global bond market now offers a negative yield. All else being equal, lower yields are good for risk assets through the discounting of future earnings.
3. Markets are a forward-looking mechanism. It’s the collective view of market participants on the future health of the economy, not current conditions, that drives asset prices. It is therefore the expectation of improvements in the future that drives markets up today. We believe markets look forward about three to 12 months on average. Given this window, the question around the discovery of a vaccine becomes very relevant. The probability of such a vaccine being available by mid-2021 is around 80%, in our view. Focusing on this allows investors to imagine a world in a somewhat normal state by then.
4. The outperformance of mega-cap technology stocks is distorting the market picture as well. The Nasdaq has outperformed the S&P 500 in the year to date, for instance, while the S&P 500 excluding the technology sector is still down in 2020. This isn’t entirely unreasonable given the different fortunes of technology companies and, say, retailers and the hospitality sector during the lockdown. It could still end up in a technology bubble, but we don’t believe we are there yet. Our bubble monitor, the Heiligenberg Index, is elevated but not yet in the stratosphere. We therefore remain overweight technology.
The combination of these four factors should give investors some comfort that the disconnect between financial markets and the real economy is not completely unjustified.
Overall, we have a neutral risk position, but have been reducing exposure to assets that may have gone too far, too quickly such as US investment-grade credit and inflation in Europe and the UK. Complementing this, we hold positions in some higher-yielding government bond markets such as Australia, South Korea, and longer-dated US Treasuries.