One of the most common questions I get is: what explains the divergence between the stock market rally and the economic downturn? My answer is that markets are forward looking and so began falling before the economic lockdown happened. Then, as policymakers announced previously unimaginable stimulus and as China’s lockdown and reopening proved successful, markets anticipated the global recovery before economic activity had actually started to recover in many regions. In recent weeks, however, I stressed that the extent of the rally seemed to suggest that investors were pricing in the best case scenario of a gradual but steady economic recovery with the assumption that health vulnerabilities would be kept in check. However, it was not clear if markets were being adequately sensitive to the degree of risk in such an outlook.
Well, markets did a major risk reassessment today. There are a number of possible catalysts. First, and probably most importantly, the equity market correction today is tied to the increase in infections in several US states. This has stoked fears that the reopening may be delayed in some regions (such as New York). This view is corroborated by looking at who were the biggest losers: banks, airlines, and energy-producers. Their financial performance will directly suffer if the reopening is delayed resulting in a more protracted recovery.
There were also releases yesterday that may have increased investors’ concerns about the health risks and the shape of the recovery. The Federal Reserve’s statement and projections suggested that its asset buying program would continue to increase and interest rates would not rise until late in 2022. Yesterday, markets responded little because the Fed’s decision was what was expected. But, the rising health risks might have triggered a thought: why is the Federal Reserve going to maintain such stimulus for such a long time? Answer: the Federal Reserve is signaling that there still is a lot of risk.
The greater appreciation of the risks may have been triggered by a reflection on the release of the OECD’s global economic forecast, which was far worse than that of the IMF, but more importantly indicated a 50/50 chance of a second wave of infection.
As I have argued in prior commentaries, this is the number one risk to the economic outlook. I am not an epidemiologist. I don’t know what the odds are of a second wave and a potential second lockdown. But, I know it is a real possibility. That is why my team has a base case forecast and then a more severe scenario where the infection balloons again. In this economic case, growth picks up in the late Summer and early Fall due the current reopening, but then the economy contracts again in the Winter and next Spring. A sustained recovery comes but only well into 2021.
Today’s pullback in equities, retreat in oil prices, and rally in bonds is consistent with a reevaluation of risk. Will this continue and will markets continue to retreat? It is possible, but if the risk of a renewed infection does not materialize, markets will recover the ground they lost. In my opinion, we should be prepared for significant financial market volatility. Typically markets take two steps forward before taking one step back. However, the experience this year has really been a dramatic run backwards followed by a sprint forwards. There was a period of intense fear followed by period of intense relief. We were overdue for a pullback in equities and commodities. I expect that we should see a greater tug of war between the bulls and bears in the weeks to come, with the consequent volatility.
