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A common question I have received is what explains the disconnect between financial markets and the economy? This is a natural question because the two seem to have headed in opposite directions in recent weeks.
The economic data streaming in is showing the depth of the decline in March and April. Indeed, last week’s reported drop in US retail sales and industrial production are consistent with a 40 percent annualized decline in the US economy in the second quarter. Today, we learned that US housing starts fell by 30 percent in April. Troublingly, the Canadian data suggests a similar sized economic contraction in the April to June timeframe.
Conversely, equity markets have rallied strongly, with the S&P500 closing on Monday at a two-month high. In commodity markets, oil prices are still low, but the price of West Texas Intermediate crude has risen from a trough of below US $20 a few weeks ago to almost US $32 a barrel today.
The answer to the dichotomy is that financial markets are forward looking while most economic indicators are lagged. Equities and commodity prices plunged before the economic lockdown. As investors saw the signs that the epidemic in China would spread to become a global pandemic, they priced a severe recession into asset valuations. This came before the economic numbers recorded the downturn.
Then, in the wake of announcements of massive fiscal and monetary stimulus, investors started to believe in an eventual economic recovery. This sentiment became more dominant as there were signs that the number of net new COVID-19 cases started to flatten out in Europe and then in North America. This led governments to start discussing plans to reopen the economy, which investors anticipate will lead to higher earnings in the future. Markets are also monitoring progress on a vaccine as an input into their choices. While, the economy is sinking, markets are looking to the future.
The crude oil story is a bit more nuanced, but follows a similar dynamic. Not only did the global pandemic cause a massive drop in demand, but a bad decision by OPEC to keep supply flowing led to a collapse in oil prices. Indeed, as inventories were filling up, the futures contracts on oil temporarily experienced negative prices because no one wanted delivery of the product. Oil prices have since picked up because OPEC reversed direction and committed to reduce supply while production by non-OPEC producers has fallen. Consequently, inventories are rising less quickly. Moreover, signs of a reopening of the global economy are lifting expectations of future demand. Taken together, this chain of events has lifted crude oil prices recently.
This is why we have included stock market indices and commodity prices in our Deloitte Economic Recovery Dashboard (click here to view it). The prices of assets embody the expectations of millions of investors about the future demand for goods and services and profits. Thus, they often act as leading indicators of economic activity and potential recovery.
However, given the extent of the recent rally, one should be reminded that markets typically take two steps forward before taking one-step back. Rallies are not smooth and steady. They are often characterized by considerable volatility. This reflects the fact that expectations can get too upbeat and then developments can disappoint the extent of the perceived improvement in earnings.
In my view, the market has had a good run, but it is likely overestimating how easy it will be to reopen the global and the Canadian economy. Just one Canadian example, but we still do not have adequate essential medical equipment. The virus is still in circulation via community spread and this will impact consumer behavior and buying habits. Business investment will remain low as firms can be expected to continue to operate in survival mode. I have no doubt that any level of reopening will lead to large percentage gains in the economic data, but I believe the level of economic activity will remain depressed. I would argue that markets are right to expect recovery, however the pace of that recovery may prove to be disappointing.
This week has a relatively light economic calendar. The main event in Canada will be tomorrow’s release of the Consumer Price Index for April. The headline inflation rate could show that aggregate prices are slightly below year-ago levels. If this happens, there will likely be headlines about deflation risks, but that would be the wrong interpretation. The bulk of the price decline will be in energy prices. Excluding food and energy, inflation is expected to be around 1.5 percent. That is below the Bank of Canada’s 2 percent inflation target, but it certainly is not deflation.
Canadian retail trade numbers will be released on Friday and they are expected to show a dramatic decline of 10 percent in March. This data will reflect the picture two months ago leaving out the blows the sector has received in April and May as lockdown measures persisted.
Key US releases will be the Federal Reserve’s Federal Open Market Committee minutes tomorrow, purchasing manager indices for manufacturing and services on Thursday, and existing home sales on Friday.