FINANCIAL MARKET COMMENTARY FOR GIBRALTAR CHRONICLE
BY FIDUCIARY WEALTH MANAGEMENT
This is a first in a series of articles which addresses the ‘Great Disconnect’ between stock markets and the real economy and considers alternative strategies to protect your wealth from the economic impact of Covid-19.
Governments are facing the ‘Great Conundrum’ – the seemingly competing objectives of gradually unlocking economies to protect jobs and drive growth without endangering lives and overwhelming global healthcare systems. A moral dilemma which has no modern parallels.
The phased reopening of the global economy hasn’t been smooth. Many countries are struggling to bring the virus under control heightening the risk of new partial lockdowns and restrictions.
Meanwhile, hopes of developing an early vaccine which doesn’t compromise on safety, is effective in providing immunity and be widely and speedily deployed are fast receding.
Investor sentiment is also being weighed down by non-virus issues such as an upcoming US Presidential election which is blocking the path to a new USA stimulus package; with economists racing to revise downwards their growth projections for the remainder of the year.
There is a massive disconnect between asset prices and economic fundamentals which are liquidity driven (i.e. printing of money) and supported by political rhetoric – ‘of doing whatever it takes to keep the global economy afloat.’
The size of the global stimulus response already exceeds past stabilisation packages including that provided to combat the Global Financial Crisis – see graph.
Policy makers are pursuing short term policies to maintain the stability of financial markets rather than laying the foundations to drive future long- term growth.
Expanding the monetary base and increasing government spending to avoid a recession remains politically acceptable but the painful unwinding of past excesses and macro imbalances, which are necessary evils, are not on the menu.
A reasonable level of debt is the oil that lubricates the wheels of an economy but excessive over-indebtedness produces diminishing returns (i.e. less growth and deflation.)
Japan is a case in point. The level of debt spiralled out of control in the 1990’s when the real estate bubble burst. Thirty years later it remains locked in a low growth, deflationary cycle; in which the Bank of Japan needs to purchase government debt to maintain an ultra-low accommodative interest rate environment in order for the debt mountain now standing at 240% of GDP to be serviced. Significantly the Nikkei Index continues to trade circa -40% lower than its 29 December 1989 peak of 38,957.44.
We cannot resolve a debt crisis (from which we have yet to recover) through greater indebtedness. All this does is force the monetary authorities to suppress interest rates to make the debt more manageable locking the global economy in a low growth path – pushing us ever closer towards negative interest rates.
Central banks are injecting massive liquidity into the monetary system but the velocity of money (i.e. the speed at which money exchanges hands in an economy) which is a key determinant in driving economic growth is crashing producing a negative multiplier effect.
Damning evidence that the policy response (which some consider a necessary evil) is not yielding the desired economic outcomes. See graph showing interaction between money supply, GDP and the velocity of money.
We had weaker corporate fundamentals (i.e. declining corporate earnings) before the onset of the pandemic. The following graph shows a disconnect between stock prices which are surging and corporate earnings in sharp decline.
And of course, the most severe quarterly global economic contraction on record; far exceeding the Global Financial Crisis and Great Depression – see graph.
Even after making allowances for the fact that stock markets are forward thinking and pricing in future economic activity Post Covid-19; the explosive rally in share prices is totally unjustifiable.
In the midst of the most brutal economic contraction on record; the US S&P500 Index trades at 25x forward earnings compared to a historical average of 16x. These extreme valuations are more noticeable when compared to past periods of economic uncertainty where it’s traded at an average of 13.6x forward PE.
Are equity markets coming to their senses or just waiting for another round of money printing to keep the party going for a while longer?