The Covid-19 pandemic has decimated health services and global economies throughout the first half of 2020. Government-enforced lockdowns left many businesses unable to operate entirely, with those that have survived working at a greatly reduced capacity. Unemployment has increased greatly on a global scale, and incomes have also taken a massive hit. The US notably recorded an unemployment rate of 14.7 per cent in April, the highest monthly unemployment rate the US has recorded since 1939.
This is a huge blow to consumer purchasing power, and high levels of financial uncertainty will encourage consumers to save rather than spend. This is reinforced by the fact that consumers have considerably less spending options - high street stores have only recently opened in the UK and remain closed in many regions of the world. E-commerce is the only real option that is impermeable, and, as such, one would have to assume that the economic outlook is rather gloomy. Thus, as expected, most economies have fallen into a recession and are declaring it with the natural time lag that comes from defining recession as “two consecutive quarters of GDP decline”.
So, the question as to why the S&P500’s year-to-date performance is flat (at the time of writing) is confusing many who clearly see the widening disparity between Wall Street and the high street.
Therefore, while I will try to explain why this phenomenon is happening, it is important to note that there will be a great deal of other variables which will also impact the stock market.
Firstly, it is important to think about the psychology of the stock market investor. The stock market investor sees the value of an asset as the sum of the cashflows during the period of holding the investment (usually 5-10 years), discounted to account for the risks present in achieving these cashflows. This method of valuation is called a Discounted Cash Flow and is used widely by professional investors and executives. Now, as this function below shows, over 90% of the cashflows and value creation from an asset occurs after the second year. Thus, with a majority of scientific opinions seeing a Covid-19 vaccine to be in circulation by late 2021, investors seem to be extending out their investment horizon to a point in which revenues and cashflows to shareholders will be far less affected by the virus.
A second aspect in this DCF formula above is the riskiness of the cashflows, surely the cashflows in this present uncertain time are extremely risky and would still lead to a stock market crash? Well, sort of. The discount rate is a formula in itself built from the risk-free rate (usually US Treasuries), plus a country risk premium (important when dealing with unstable geopolitical regimes), plus an equity risk premium which accounts for the risk coming from exposure to the broader stock market. Therefore, with US treasury rates being so low (10 year yields being at 0.75 per cent at the time of writing) and the perceived stability of US government giving no premium for country risk, even though equity risk premiums have risen to 6 per cent the discount rate would not restrict asset values as much as would be expected.
Secondly, the US is funding stimulus to the tune of $2 trillion as part of its CARES act and increasing the national deficit to $2.9 trillion according to analyst expectations. With all this debt funded stimulus, the Fed is pushing government interest rates across the yield curve to the lowest levels ever seen. Currently, the Fed is holding rates at 0 and Chairman Powell has said that he “is not even thinking about thinking about raising rates” through 2022. Additionally, the Fed has entered the corporate bond market by buying debt of US corporations via a broad ETF. By doing so, the Fed has pushed bond yields down to incredibly low levels to which they are no longer attractive, and then shown to endorse significant risk appetite from the market under the guise that the Fed will have the individual investor’s back as the bidder of last resort.
A further effect of the pandemic's impact on financial markets is the increasing levels of volatility. This can be most evidently seen with the Vix Index, Wall Street's fear gauge, reaching highs of 85 at the end of March before calming more in recent months. Levels of volatility such as this provide a fertile environment for banks' trading profits which have seen record Q2 figures and provide some ballast against equally high loan loss provisions.
In conclusion, the effect of government intervention in markets has clearly been shown to cause market mispricing across all sorts of asset classes with unforeseen consequences yet to come. The rampant and immediate borrowing of the government to stimulate now at the expense of bondholders, pension funds and the younger generation will become increasingly obvious as the interest burden will have to be repaid via higher taxes or inflation. With this in mind, there is a daunting economic backdrop even after we emerge from this pandemic and it is unclear as to whether it will be worth it until we eventually feel the consequences of the decisions we now make...but until then there will be heavy volatility both up as well as down.