Equities rally into the downturn A view from London

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Economists are still coming to grips with the reality of a freezing of economic activity. Last week the International Monetary Fund warned that the coming downturn was likely to be the worst for the global economy since the Great Depression of the early 1930s.

On the same day the UK’s official forecaster, the Office for Budget Responsibility, said that a three-month lockdown could cause the UK economy to contract by 35% in the second quarter of this year. This is an astonishing hit, roughly equivalent to unwinding 16 years of growth in just three months. Meanwhile economists at the St Louis Federal Reserve estimate that the US unemployment rate could rise to 30%.

So if the economic outlook is so dark, why are global equities rallying?

The US S&P 500 index has risen by 28% from the low it hit on 23 March and is only 15% below the all-time peak reached in February. Other major equity indices have seen significant, though lesser gains. After the longest US equity bull market in history, and with the world heading into what looks likely to be the deepest downturn in over a century, the S&P 500 is only back to the levels of last summer.

A vast programme of central bank and government stimulus has bolstered equities even as forecasts for growth have gone into freefall. The boost to global activity from easier fiscal policy, through increased public spending and tax cuts, is far greater than in 2008–09, and especially strong in Japan, the US, Germany and the UK. Governments are seeking to help corporates and households through the crisis with loans, tax holidays and a range of measures to support incomes. Central banks have re-started their programmes of asset purchases to boost liquidity, drive down interest rates and bolster risk assets. The Federal Reserve has gone further, promised unlimited quantitative easing, and, for the first time, promised to buy riskier, sub-investment grade, or junk bonds. The message is that policymakers will do whatever it takes to support growth and markets.

Investors have taken note. Their renewed enthusiasm for equities seems to be predicated on the idea that it is unwise to fight central banks - if central banks want to raise asset prices they have infinite ability to create money, and to make it happen. The hope, too, is that easier monetary and fiscal conditions will ensure that the slowdown is short-lived and that activity, and profits, will bounce back next year. In a world of ever-lower interest rates, equities do offer investors the prospect of long-term income. Markets have probably also taken some encouragement from signs of a peak in COVID-19 infections and a partial and cautious easing of restrictions in some European countries.

Yet, as far as the economy is concerned, we are in perilous waters. The scale of the downturn and the timing, and magnitude, of any recovery, are unknowable. Central banks and governments will not be able to prevent all damage to the productive capacity of the economy. If the legacy of this crisis is deep economic disruption, elevated debt levels and greater caution, long-term growth is likely to suffer.

The actions of policymakers have had a catalytic effect on equity markets since late March. We must hope that these actions prove as successful in supporting growth beyond the downturn.