June 17, 2020

“The path ahead for the economy is highly uncertain and continues to  depend to a really significant degree on the path of the pandemic.”

 - Federal Reserve Chairman Jerome Powell 6/10/2020

Executive Summary

  • The stock market remains connected to economic realities, but with a focal point further in the future

  • Vaccine progress has been swift and positive, but nothing is guaranteed

  • Our models suggest the S&P 500 is currently trading near fair value when future growth, interest rates and inflation are considered

Is the stock market disconnected from the economy?

Bear with us before we answer the question . . . or skip three paragraphs; your choice. A few principles of equity valuation are in order to understand the question more fully. First, it is worth noting that equities are very long-duration assets whose value today is determined, conceptually speaking, by projecting out all future cash flows and discounting them to present value using an appropriate discount rate. Second, the “discount rate” employed should consist of an interest rate, which includes an inflation expectation, and an additional premium for investing in risky assets. In this conceptual world, a couple years of depressed earnings has only a minor impact on equity valuation if one assumes the economy will bounce back and the longer term-trend will remain largely intact.

In the real world, however, stuff happens. Market participants don’t really know how steep or long-lasting a downturn will be or even if the long-term trend will remain intact. In periods of heightened uncertainty, the risk premium demanded by investors to hold equities typically shoots up, which adds downward pressure on prices. Conversely, accommodative monetary policy, along with falling interest rates and inflation, can help stabilize equities by lowering the interest rate component of the discount rate, but only if investors believe the changes to be long-lasting. And finally, fiscal stimulus is often a “wild card” that takes a long time to negotiate and implement, but in the current downturn it has been swift and large, resulting in a 10.5% surge in personal income in the most recent government data (Exhibit 1).   

 
 

We believe that unprecedented monetary policy and fiscal policy support, along with falling inflation and interest rates, have enabled market participants to focus more on the long-term economic prospects rather than be gripped with short-sightedness as is typical in recessions. Our modeling of long-term expected stock market returns indicates that the net effect of sharply lower short-term growth, modestly lower long-term growth, and lowered interest rates and inflation puts the fair value of the S&P 500 near current levels. 

Whether you have slogged through the above paragraphs or just skipped ahead, here is our answer: There is not necessarily a disconnect between equity market prices and the economy, but rather a connection that exists further in the future than what many market participants are accustomed to considering. However, this willingness to look past the present difficulties, while reasonable, elevates two considerations. One, a damaging secondary outbreak or unfavorable vaccine developments could bring markets back to a more typical recessionary myopia. Two, anchoring in the more distant future means that any cracks to the longer-term landscape could result in large market swings. 

Stimulus vs pandemic

The Fed’s June 10 release of economic projections included expectations that short-term interest rates are likely to stay near zero all the way through 2022. The Fed’s asset purchases are likewise set to continue. Chairman Powell is steadfast.

On the fiscal support front, an additional package is widely expected to pass prior to the early August Congressional recess, but there is a wide gap in priorities between the proposed stimulus package passed in May by the House and the indications coming from the Trump administration and other Republican leaders. Compromise will surely be necessary, but expect Republicans to push strongly for back-to-work incentives and manufacturing on-shoring incentives. The size of the final stimulus package remains uncertain, but we expect it to be significant.  

Changing economic landscape

It’s quite a testament to how much economic realities and markets can change over time that massive government borrowing and deficits are not driving up interest rates. With the support of Fed purchases, we expect the market to absorb the coming debt issuances to fund fiscal stimulus. Our base case remains for interest rates to stay low throughout the pandemic and to rise only modestly over time. Low interest rates, coupled with recent dollar weakness, have also helped to support emerging market assets by alleviating strains to fund dollar-denominated debt.

In Europe, individual countries are also pushing ahead with fiscal stimulus, and more importantly, European leaders are negotiating a pandemic stimulus program that would entail 750 billion Euros in borrowing backed by the E.U. as a whole.  The Euro’s recent rise against the dollar is indicative of how much financial markets welcome these stimulus prospects by an E.U. that is prone to fiscal policy disagreement. Assuming an agreement is reached, it will be an important economic boost and also a precedent-setting event.

Re-opening and the vaccine race

Given economic re-opening, fiscal stimulus, monetary policy support, falling COVID-19 cases, and news headlines that have shifted from medical to social issues, it may be easy to forget that different countries are at very different stages in the pandemic (Exhibit 2). Even within the U.S., there is great disparity in trends on a state-by-state level, and concern over a handful of states that have rising hospitalizations and increasing “positivity rates” of testing. While it’s certainly possible for states to experience different paths of the outbreak, the broader concern is that even regional acceleration may be indicative of the need to maintain greater precautions and slower economic activity until mass immunity is achieved, presumably through a vaccine. We are optimistic on vaccine availability by year end based on current data, timelines, and multiple trials underway, but clearly achieving such a record-setting timeline is not guaranteed. Lasting economic damage could pile up if the date is pushed out.

 
 

Indeed, the market’s willingness to look through near-term disruptions and focus on a future “return to normal” stage is not unassailable. We remain cautiously optimistic, but similar to Chairman Powell, sober in our assessment.    

 

 

 
 
 
 
 

 

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