Why is the stock market rising in the middle of a severe recession?
The economic carnage inflicted by the fight against the coronavirus pandemic has been real—and horrific. More than 40 million Americans and 3 million Canadians1 have filed for jobless claims since mid-March, when both the U.S. and Canadian economies went into lockdown mode to slow the spread of the virus. The official unemployment rate in the U.S. stands at nearly 15%—the highest since the Great Depression—and will likely edge closer to 20% this Friday, when the nonfarms payroll report for May is released. And, after shrinking 4.8% in the first quarter, some are forecasting that U.S. GDP (gross domestic product) could contract by a staggering 40% in the April-to-June timeframe.2 It is much the same in Canada, where the unemployment rate now stands at 13% and GDP fell by 8.2% in the first quarter.3 There is no doubt that North America is smack-dab in the middle of a severe recession, unrivaled in magnitude in the past 80 years.
Yet, you wouldn’t know it by looking at the stock markets. Major U.S. benchmarks have clawed back a large percentage of their first-quarter losses, with the S&P 500® Index and the Dow Jones Industrial Average back to levels last seen in early March—roughly a week before the worst of the selloff hit. In Canada, the benchmark S&P/TSX Composite Index has had a similar experience, despite the sagging economy and low oil prices. The disconnect between Main Street and Wall Street (or Bay Street in Canada) is perhaps more pronounced than it’s ever been in recent memory. How can this be? Why are equity markets rising in the teeth of the storm?
The answer is simpler than it may seem. Markets, first and foremost, are forward-looking vehicles. They focus on the future, not the present or the past. And when markets peer out around the corner, we believe they see three things in particular that spell better days ahead for equities.
1.) The expectation of better news
The first factor likely driving market performance today is the widely-held belief of better news to come. To be clear, this is not an unfounded, overly optimistic expectation. The avalanche of bleak economic data that’s roiled the world over the past few months is a direct result of the necessary government-mandated economic lockdowns that spread from east to west in February and March. When businesses and factories are shut down, jobs are lost. Consumer spending plummets. An economy brought to a standstill is going to look just as bad on paper as it does in real life. And that’s exactly what’s happened over these past few months.
But, importantly, the global economy is no longer at rock bottom. Starting in April, European countries began easing their lockdown restrictions and slowly reopening in piecemeal fashion. This trend spread to North America in May.
As the U.S. and Canadian economies begin to rebound, so too will the economic data. Improvements in manufacturing and services PMIs (purchasing managers’ indexes) are likely. In the U.S., preliminary PMIs from May already indicate this. As more businesses reopen, the pace of job losses will continue to slow. Consumer confidence should also slowly tick up, as evidenced by the latest survey from The Conference Board.4 A slightly more confident consumer will be likely to spend a bit more—granted, not to anywhere near pre-pandemic levels, but certainly to a level higher than what was observed at the peak of the lockdown. We can expect a similar process to take place in Canada. Simply put, the more an economy reopens, the more the overall data will improve. And it’s this expectation of better economic data that we believe is helping to propel markets forward.
An important caveat to note here is that certain sectors of the economy are likely to fare much better than others during the reopening phase. For instance, the travel and tourism industry—severely battered by widespread stay-at-home orders—likely faces a much slower recovery, as would-be travelers leery of catching the virus or scaling back on their vacations to accommodate social distancing requirements skip traveling altogether.
It’s safe to assume that the travel and tourism sector will likely churn out dismal numbers for some time. But it’s important to realize that this industry accounts for just 3.3% of direct global GDP.
2.) Unprecedented fiscal and monetary stimulus
We believe the second factor in markets’ continued upward climb can be attributed to the speed and vast amounts of fiscal and monetary stimulus injected into the global economy since March. Such levels of government-provided stimulus are unprecedented in the post-World War II era.
For instance, in the U.S., the CARES Act5 passed in late March and the additional funds that came in the next round of relief amount to approximately 13% of America's annual GDP. That’s a staggeringly large number in scope. And the U.S. is not alone. Canada and Australia have also passed relief packages comprising similar percentages, while Japan takes the cake with a package consisting of a whopping 40% of its yearly GDP—in reality, likely a somewhat inflated number, but still large by any measure.6 Coronavirus aid passed by the UK government amounts to roughly 6% of its annual GDP, while the European Union is currently floating a response plan of US$2 trillion dollars for its 27-member bloc.7
Meanwhile, central banks around the world have significantly expanded their lending efforts, spearheaded by the U.S. Federal Reserve (the Fed)’s Main Street Lending Program, which encourages banks to lend to small- and medium-sized businesses. Under this program, the Fed will purchase up to US$600 billion dollars in bank loans. In addition, the Fed is wading into unprecedented territory by buying US$750 billion of corporate bonds—including high-yield bond ETFs (exchange-traded funds).
Collectively, all of this aggressive fiscal and monetary support is akin to throwing vast amounts of fuel on a sputtering fire. As lockdown restrictions ease and more businesses reopen, that fire—the global economy—will rekindle. Markets, for their part, are betting that the fire will be able to sustain itself for a decent length of time.
Put another way, there’s still a tremendous amount of stimulus that has yet to work its way through the economy. Once it does, markets are essentially saying, don’t bet against it. Why? Because while the economic damage inflicted has been massive, so too has been the amount of first aid.
3.) Low discount rates
From our vantage point, the third—and perhaps most significant—factor driving the equity market’s recovery are today’s really low discount rates. Why? Recall that stocks are ultimately priced on the net present value of a company’s future earnings
With this in mind, there are two ways to increase the net present value of future earnings: by achieving higher earnings growth, or via low discount rates. We believe that the unprecedented actions taken by the U.S. Federal Reserve, the Bank of Canada, and other central banks since March to lower both interest rates and credit spreads have resulted in very low discount rates today.
If, for example, we use today’s 10-year U.S. Treasury yield of 62 basis points as a barometer for the discount rate of equities, then a dollar of earnings five years from now is worth almost as much as a dollar today—at approximately 94 cents. Such an extremely low discount rate would almost entirely compensate for any disruption in short-term earnings, as a company’s required earnings growth over the same time period wouldn’t need to be as impressive. The bulk of the increase in net present value would come from the discount rate.
Simply put, a dollar of earnings for a company five years down the road is worth a lot in today’s dollars. And if you have strong confidence in the earnings of a company five years from now, you’re going to be willing to pay more for that company’s stock now.
The assumption underlying all of this is a belief in markets that by the end of 2021—roughly 18 months from now—the U.S. economy will return to the size it was in January 2020. If, by contrast, discount rates were higher and it took until the end of 2022 for the U.S. economy to return to pre-pandemic levels, equity valuations would be meaningful impacted more (to the tune of an approximate 10% loss in earnings potential).
Ultimately, low discount rates mean less concern over the pace of an economic recovery and more of a focus on the fact that such a recovery is occurring. This, in turn, allows markets to have a much longer time horizon. This is why we believe that markets will continue to be very support of equities over the next few months. With U.S. Treasuries likely to remain at extreme lows for some time, stocks have essentially become one of the cleanest shirts in a dirty hamper. And who among us wouldn’t pay a little extra to snap up the best shirt available?
The bottom line
The coronavirus pandemic has dealt a crippling blow to the world, with untold suffering and death reaching every corner of the globe. Necessary government-imposed shutdowns to control the spread of the virus brought the world economy to its knees in April—but with more of the globe entering the reopening phase, we believe rock bottom has already been reached. Assuming the spread of the virus remains under control, the economy has nowhere to go but up. That is a big if, though—and the potential of a second wave of infection remains far and away the biggest threat to the economy and markets. That said, in those countries that are farther along in dealing with the health crisis of coronavirus, we have yet to see a broad-based second wave appear.
Equity markets, as forward-looking vehicles, are latching on to this belief. Buoyed by unprecedented fiscal and monetary support from governments worldwide, the stock market has risen from the depths of its mid-March lows on the assumption that brighter days surely must be ahead.
Let’s raise a glass to this expectation, and hope it comes to pass.
2 Source: https://www.cnbc.com/2020/05/15/gdp-could-decline-by-42percent-in-the-second-quarter-according-to-the-atlanta-fed.html 3 Source: https://www150.statcan.gc.ca/n1/daily-quotidien/200529/dq200529a-eng.htm
5 Coronavirus Aid, Relief, and Economic Security Act, a US$2 trillion economic relief package.7 Source: https://www.wsj.com/articles/european-union-sets-out-major-coronavirus-recovery-plan-11590579779?mod=hp_lead_pos1