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Stock Market and Economy: The Disconnect

by Tavaga Invest

Movement of stock indices do not always reflect the broad economic indicators

By: Tavaga Research

Layoffs, salary cuts, and unforeseen medical expenses have led to 80 lakh EPFO (Employee Provident Fund Organization) members withdrawing Rs 30,000 crore in less than 4 months, beginning April 2020.

Fresh lockdowns are being imposed by local governments (municipal corporations and state). According to Google Mobility Indices (GMI), the traffic on the streets has decreased. As per CMIE (Centre for Monitoring Indian Economy), the consumer sentiment since it hit its low in March this year, hasn’t yet improved. The production of capital goods is still far from pre-COVID levels. Banks have become too conservative while lending to small businesses and other retail individuals and corporates. 

The unemployment rate which had slowed down in June due to nationwide reopening has again shot up in the month of July because of stringent lockdowns by local government bodies. Despite all this, equity as an asset class has ignored all these weak economic indicators and continues to rise since its lows of March. The Nifty 50 index plunged 40% in March to hit a year low of 7,511. However, since then, with the volatility index cooling off, Nifty has managed to climb 50% and reclaim the levels of 11,300 in July.

1-year Performance of the Nifty 50 Index

1 Year Performance of Nifty 50 index
Source: Google Finance

Such movements in indices are not only witnessed in India, but this has become a global phenomenon now. Despite disappointing economic indicators and fears of recession, global equity indices have witnessed one of the biggest stock market rallies ever.

1-Year Performance of the NASDAQ Composite Index

1 Year Performance of the Nasdaq Composite Index
Source: Google Finance

Why this Dichotomy between Global Stock Markets and Global Economy is a Bad Omen?

With RBI and central banks of other nations providing financial stability and liquidity cushions by way of policy rate cuts and open market operations, investor expectations have risen concerning economic recovery. Along with the central banks, even the elected governments have come out with special fiscal stimulus for businesses and citizens. Because of all this, the level of confidence boost concerning investors is so high, that even the riskier investments now have narrow credit spreads.

Even in the US, the sustainability of this stock market rally raises questions as consumer confidence continues to drop. The International Monetary Fund (IMF) too, has found this movement of global stock markets very hard to believe. 

This level of disconnect is inappropriate on many levels as the equity markets can again plunge because of various reasons:

  • Central Banks might exhaust their options to provide relief to sectors
  • Return of nationwide lockdowns globally, due to the second wave of coronavirus
  • Deeper than anticipated economic contraction
  • Rising geopolitical tensions and border disputes

What Factors might have contributed to a Sharp Global Stock Market Rally?

  • Too much optimism on a ‘V-Shaped’ Recovery: Central governments have resorted to opening-up of economies from the month of June, which has primarily raised expectations of investors and analysts of a speedy economic recovery. Currently, in India, none of the metro cities are under a stringent lockdown. Moreover, the recovery rate of patients from various countries has gone beyond 50%. With hopes of a vaccine by year-end, many have placed bets on a ‘V-Shaped’ recovery of the economy
  • Fiscal Stimulus: India had announced a special package of Rs 20 lakh crore which amounts to almost 10% of India’s GDP for the agriculture, manufacturing, and services sector. The United States decided to provide a relief of US$ 2,907 billion equivalent to 13.6% of the US GDP. The size of the response by every nation has been huge which has led to a lesser impact than what was anticipated at first
  • Quality matters during tough times: The handful of stocks who contributed a lot to a particular index have been blue-chip companies with steady earnings yield, strong management, and a history of good corporate governance. Reliance, TCS, HDFC twins, Hindustan Unilever, and Infosys account for 46% of the total market value in Nifty. These 6 companies did the good work of lifting the index beyond the levels of 11,000
  • Markets look at the future and discount it: Equity markets prefer to stay ahead of the reality curve, they are forward-looking and sometimes care less about the historic economic data
  • Low bond yields: With bond yields softening, many investors might have turned to equities from debt markets. As of 30th June 2020, 86% of the global debt market traded with yields not more than 2% and greater than 60% with yields less than 1% 

United States 10-Year Government Bond Yield

United States 10-Year Government Bond Yield
Source: Trading Economics, Tavaga Research

US Stock Market Recovery and Unemployment Data: Comparison of 2 Events that Rocked the Nation

Global Financial Crisis (GFC) and the Coronavirus led recession in the US came in as a shock to the financial sector. The global financial crisis was a consequence of excessive risk in the financial sector and it further contaminated the entire real economy through demand destruction. Even though the solution to this problem could’ve taken a long time, it was still actionable by bringing-in the confidence in the financial sector by repairing it, which would eventually revive the demand and as a result, the supply.

The recession due to COVID-19 is a consequence of a virus/disease that originated in the real sector and was later transmitted to the financial sector. The quantum of uncertainty during this pandemic is much higher than the GFC as the solution to this is only the vaccine which will inspire confidence in the real economy and bring back stability in the financial sector.

Even the unemployment rates during these two events indicate that the levels of joblessness during the global financial crisis (7.2% in December 2008) was much lower than the present one (13.3% in May & 11.1% in June 2020). Despite all this, the US indices have soared and are closer to the highs observed in January and February. On the other hand, it took 6 years for the S&P 500 to recover to its previous all-time high during the GFC.

Unemployment Rate

Unemployment Rate
Source: Bureau of Labor Statistics, US

The falling unemployment rate since May 2020 is encouraging but the jobless rate is still 7% above the levels observed in February.

That said, it is important to note that the S&P 500 took only 1 year or less than 1 year to recover to its previous all-time high, in 8 out of 12 historical drops.

Years to recover to previous all time high - S&P 500 index
Source: Tavaga Research, fourpillarfreedom.com

Only those investors who chose to accumulate good quality businesses during deep corrections have been rewarded by the stock market. For Indian indexes, the economic slowdown might have become a thing of the past with the market factoring-in the future recovery. 

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