The S&P 500 gained over 35% from the March lows. To some, this increase appears incomprehensible in light of the current economic data, which reflect the damage caused by the closure of economic activities after the outbreak of the coronavirus. Many wonder if the financial markets are anticipating the economy, and if this is right. At the risk of revealing our conclusions too early, the answer to both questions is yes. The next question to ask is which economic scenario the financial markets are forecasting, or which future cash flows they are discounting.
It is generally accepted that investors discount, or take into consideration, all available information, including the current situation and potential future events. This means that the prices of the securities (bonds and shares) significantly reflect the expectations regarding corporate profits, defaults, inflation as well as monetary and fiscal policy. One of the consequences of extremely low interest rates and bond yields is that longer-term expectations have a potentially greater impact on the prices of current securities than they generally do in higher-interest rate contexts.
Although in arithmetic terms it is correct that current stock prices are to a large extent an expression of future expectations, it is also true that they reflect opinions about the current conditions of liquidity and capital solidity of companies, as well as the stability of the financial system in general. . It makes no sense to admire a building without knowing anything about the solidity of its foundations.
The valuations of companies listed on world stock exchanges are often multiples of the expected operating profits. Graph 1 shows the range of price / earnings (P / E) ratios that investors have been willing to pay in different markets over several years. Since the P / E is never 1, investors seem willing to consider multiple future years.
Faced with major unforeseen developments, investors tend to move quickly, attempting to incorporate new information into stock prices. The efficient markets hypothesis is based on the assumption that investors as a group constitute a very efficient discounting mechanism. If efficiency means the rapid incorporation of all new public and accurate information, then I too am of the opinion that markets are efficient.
For example, when a company publicly announces its earnings estimates, the possible range of interpretations of investors is relatively narrow, so the adjustment of the valuations of the related securities is quick and accurate. However, in a more complex situation such as that created by a global pandemic or a global financial crisis, investors act quickly but the range of interpretations is wide, both in the short and long term. Social media has greatly accelerated the circulation of a much larger number of opinions and theories (but not necessarily of facts). Consequently, it is less obvious that the initial market reaction accurately reflects the possible consequences.
The reaction speed is clear: the rapid increase in volatility, which occurs in conjunction with the occurrence of important unexpected events, is evident in the graphs below (Figure 2). From a technical point of view, volatility is a statistical measure of the dispersion of the returns of a security or market index over time. From a practical point of view, it is a barometer of investor uncertainty about the immediate and longer term implications.
As my colleague Toby Nangle, Global Asset Allocation Manager, notes: “In the current crisis, to what extent the decline in stock markets and the rise in corporate bond yields are due to an informed increase in investors' future expectations (deterioration of economic conditions and credit parameters and an increase in insolvency rates) and what about the liquidity stress that simultaneously hit the financial markets, and which central banks have tried to compensate for? There is an interrelation between these two developments and causal relationships are not easy to establish. However, if the risk premia are high because they incorporate the future collapse of the economic activity and consequent mass bankruptcies, the prices could be excessive. If, on the other hand, they simply reflect the malfunction of the financial system, there may be opportunities for investors operating in the medium term. This is because, if central banks cannot reduce the risks of insolvency, they can nevertheless fix a financial system that does not work: it is part of their mandate, and for this purpose they can draw on unlimited resources ".
Note the speed of the increase in volatility and the consequent drop in the graph at the top left. The initial rapid response seems to reflect the degree of surprise and the initial perception of the severity of the problem as it occurs. The slower decline in volatility appears to reflect the time taken to reach a consensus opinion on the future scenario.
Although stock market indices do not entirely reflect the range of activities of the economy as a whole, we believe that price lists generally move in the same direction over time as economic data. After all, companies (and their revenues) are not detached from the context in which they operate. As global economies grow, trade in goods and services increases, fueling corporate revenues, creating favorable circumstances for the appreciation of stocks and corporate bonds. On the other hand, an economic contraction raises the probability of correction of the stock markets.
However, as prices are discounting future expectations, financial markets may also gain ground in the event of expectations of future growth despite the current difficult situation. This is what happened when the financial market collapsed after the global financial crisis in 2008, but then began to recover in 2009 before the economic recovery.
As mentioned earlier, investors' forecasting ability tends to be imperfect when the range of possible future outcomes is uncertain. Figure 3 shows the most likely assumptions in our view that the US economy will recover from the recession triggered by Covid-19. A key element of the graph are our hypotheses, which are based on the analyzes of our health research team about the developments in the health sector that will allow the normalization of economic activity as a whole. The red line indicates our projections on the evolution of the money market in anticipation of these economic and health developments. The key point is that the market does not move in conjunction with economic and health progress, but precedes it.
Financial markets are currently anticipating, as it should be, the magnitude and growth rate of global economies in 2021 and 2022 instead of focusing on current weak, retrospective economic figures. To develop and test our recovery hypothesis and our estimates for the economy as a whole, Columbia Threadneedle Investments' macroeconomic research will focus on prospects for other specific factors, including inflation and consumer spending preferences. Aggregate demand may recover, but it is essential to understand whether the goods and services purchased will change permanently. In order to make significant forecasts, a deep understanding of the current financial strength of companies, the future growth of revenues and profits, as well as the state of health of local administrations is necessary.
Once formulated, our hypothesis of economic and health recovery can be tested against the actual pace of economic recovery, which will allow us to define the implicit expectations embedded in the US stock market. Using the S&P 500 index as a proxy for the US stock market, it is noted that investors seem to increasingly rely on one of the two economic scenarios (V or U-shaped recovery) and on the key assumptions for the healthcare sector associated with them.
For us at Columbia Threadneedle, a stylized U-shaped trajectory (Figure 4) represents the most likely recovery hypothesis of the US economy, although the chances of a slower L-shaped recovery are not negligible.
However, we are less optimistic towards Europe, where the most likely are in our view of an L-shaped recovery (Figure 5).
Given these assumptions correct for the relatively modest probabilities on the trajectory of the economic recovery in the United States and Europe, Ed Al Hussainy, Head of Macroeconomic Research, predicts only modest increases in interest rates and bond yields in both regions.
Regardless of the trajectory of the economic recovery and the financial markets from the impact of Covid-19, we must not forget that before the pandemic, developed economies exhibited a long-term trend of relatively low growth, due to multi-year demographic trends, high debt levels , etc. The pandemic could change some trends in the areas of consumer spending, corporate globalization, increase in debt levels and public policy initiatives, but it is unlikely that it will accelerate aggregate demand compared to the trend trend of the last decades.
Taking into account the combined effect of the long-term economic outlook and the relatively high starting levels of stock market valuations based on the cycle-adjusted price / earnings ratio (CAPE), a parameter created by John Campbell and Robert Shiller, expected market returns may be historically low. Figure 6 shows that CAPE was 27.6 in early May. Based on this value, the prospective 10-year returns of the S&P 500 were generally less than 10% and in some cases negative. We expect average returns of 4-6% within a range of over the next 10 years
However, market valuations as a whole can be misleading. According to Empirical Research, “The high growth companies, or the 75 large caps with the best overall growth credentials, currently trade at almost five times the realized P / E of the market on an equal weight basis, a level that was not seen from December 1999. These stocks achieved extraordinary results during the pandemic, recording double-digit outperformance compared to the market both during the correction and in the recovery phase ". Rather than being an expression of great optimism about the recovery from the effects of Covid-19, perceptions of market performance and assessments could therefore better reflect investor admiration for companies that present clear growth prospects in a context in which growth has become rare. As a result, in a U-turn the distortions created by this non-objective perception could create a greater number of stock selection opportunities not limited to this restricted large cap squad.
Figure 7 shows the differentiation of investor views about the future of different industries and sectors. Investors have clearly developed various opinions about the impact of the economic recovery on the recovery of profits of the various sectors after the lockdown due to the pandemic, embracing U, V or L recovery scenarios. Such a breakdown of the scenarios seems to indicate that investors act in a more rational way than indicated by those who focus their attention on the market averages.
Investors may have too optimistic opinions about the sectors that will recover more quickly, but there will certainly be opportunities to review their opinions as the market averages will have to drop significantly.
The future is difficult to predict, so it is very difficult to make forecasts, and in part this is precisely why financial markets exist. We believe that the markets will attempt to anticipate future complex events, however recording additional volatility when their expectations change as the situation evolves. A market that does not attempt to anticipate future events would be an irrational market.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/i-mercati-anticipano-leconomia/?utm_source=rss&utm_medium=rss&utm_campaign=i-mercati-anticipano-leconomia on Sat, 20 Jun 2020 05:32:20 +0000.