The latest US jobless report showed an unemployment rate of 11.7 per cent. Many businesses are struggling to keep operating, with some of them going into bankruptcy. The full extent of the coronavirus damages will become more evident with the reopening of the local economies. In all this, the US stock market, as measured by its major indices, the Dow Jones Industrial Average and the S&P 500, have rebounded by around 40 per cent by the end of June from their mid-March lows. So why is the US stock market recovering even as the economy continues to struggle?
Traditionally, when equities fall, investors seek safety in the high quality sovereign bond market, which offers lower but less volatile returns. When the stock market is doing well, that low rate of return drives many investors away from bonds. When the stock market tumbles, less volatile returns pull investors right back in the bond market.
The equity markets began falling in mid-February on collapsing oil prices and worries about the speed with which the pandemic was spreading globally. In response, the US Federal Reserve (FED) and the government took a number of steps to support the economy − launching lending facilities to ensure that credit flows to businesses and households and buying an unlimited amount of US treasuries. The addition of high-yield bond purchases to its programme lifted sentiment even further.
Crucially for the stock market, the FED also slashed interest rates to near zero. By the start of July, the 10-year Treasury was only yielding 70 basis points, down from just over two per cent in July 2019.
While the pandemic has shuttered many brick and mortar businesses, the impact on many technology companies and businesses with strong online presence has been different. If anything, the pandemic made technology companies more important than ever, with increased demand for online communications and video conferencing boosting revenue for corporations providing such services. The positive performance of these equities has offset declines in other sectors, such as energy, manufacturing and retail. As a result, the stock market’s gains are narrow and less broad-based.
The current market recovery may be a great opportunity for investors or a dangerous trap
As mentioned in my last article, recessions do occur, but so do economic and market recoveries. Several factors helped lift investors’ sentiment. In early May, the Bureau of Labour Statistics reported that the unemployment rate was 13.3 per cent. Despite being a high figure, it was much less than what was expected at nearly 20 per cent.
Another factor is the unique character of the recession caused by the coronavirus. An ordinary recession is what economists call a “cyclical recession”. This means that the recession is brought on by some downturn in the overall business cycle in which overvalued assets lose value, risky lending halts and inefficient or unproductive businesses close.
The coronavirus recession did not begin this way. Entering March 2020, the economy was in a generally stable shape. The coronavirus recession is something new, call it a crisis or “shock recession”. Before governments ordered a halt to economic activity, businesses and workers were generally productive. While economies have all been impacted, workers, assets and businesses were fundamentally strong before the pandemic. If they can resume activity, it is possible that those businesses can go right back to making money and paying workers.
The US government has signalled strong action when unlocking $2 trillion to help businesses impacted by the virus. Based on the market’s reaction, it is clear that many investors believe that these efforts by the government and the FED are more likely to succeed than to fail, helping to stabilise and rebuild the economy in the long run.
Perhaps it should not come as a surprise that the stock market is going in the opposite direction of the economy at large. In some ways, the divide between the stock market and the economy has been growing for a long time.
Equity prices have not reflected the underlying economy for years, and now it is becoming more noticeable with major stock indices rebounding from the lows of late February.
Among factors boosting those indices are low bond yields, the strength of technology company shares and investor expectations of an economic recovery following actions from the FED and the US government.
The coronavirus recession is unlike any other recession that financial markets have experienced before. The current market recovery may be a great opportunity for investors or a dangerous trap. One must pay attention in this unpredictable time and a financial adviser can help guide investors through these uncharted waters.
This article was prepared by Adrian Mifsud, investment adviser at Jesmond Mizzi Financial Advisors Ltd. It does not intend to give investment advice and its contents should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For more information, contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on 2122 4410, or e-mail adrian.mifsud@jesmondmizzi.com.