Author Trevor Hubner
The disconnect between bond and stock markets has continued to grow in recent weeks. The degree of support that is being given to the global economy by governments and central banks is extreme, because this is what the situation requires. Unemployment levels are rising and it is looking likely that the emergence from the lockdown to any degree of normality is going to take time. Not only are governments spending more but they are also receiving far less in tax receipts as many business are not making any profit and individuals are not spending money. A look around the normally busy streets of London tells the knock on effect of people not returning to their offices. Trains are empty, coffee and sandwich shops remain shut with pubs and restaurants struggling to draw customers in. The reaction to the pandemic by governments has been swift and on an incredible scale, spending money that it will take generations to pay back.
So, with the situation being sufficiently worrying to require the extraordinary measures outlined above, you would really expect an equally pessimistic view to be taken by global stock markets. You would, however, be very wrong. With the notable exception of the UK index (the FTSE) most main bourses are again in positive territory for the month. The performance of the tech heavy NASDAQ is getting to the point of being almost beyond belief, up another 6.90% this month, it broke its record level again recently and is up an incredible 37.20% in a year (figures from Trading Economics 22/07/20). This has been particularly good news for Jeff Bezos, the founder of Amazon, who has seen his wealth rise by $47bn this year as the share price of his company has risen by 73%. He actually made $13bn on Tuesday this week alone as the price jumped by 8% !
The reason for the significant outperformance of the tech sector is that COVID has accelerated the change that was already happening in the way companies do business. At a recent conference the CEO of Microsoft, Satya Nadella said that there had been 2 years of digital transformation in just 2 months and it seems very unlikely that the situation will reverse as normality returns. It is therefore understandable that the so called “new economy” of tech has outperformed as the digital revolution has sped up. The vast majority of the stock market performance we have seen in the past few months has been driven by the tech sector, explaining why the indices that are weighted to such companies have risen so much faster than those like the FTSE, which with its weighting to old economy areas such as oil and financials, has lagged.
Despite understanding the reason for the tech rally, it still really does look like either the bond market is correct and we are in for a prolonged downturn, or the stock market is right and, while there will undoubtedly be some failed businesses, for the survivors the return to normal will be relatively swift. However, it may not be as clear cut as that and perhaps there are reasons to think both are correct.
Firstly, as mentioned previously, the central bank support is on an enormous scale and pumping this amount of money into the system is bound to inflate asset values, especially as low interest rates make holding bonds less attractive. In other words holding assets makes sense and demand has driven up prices. A second consideration is that stock markets are forward looking, they understand that currently the situation looks grim, but, mainly because of the massive intervention, they are increasingly optimistic for the future. This also goes some way to explain why the rally has been dominated by those sectors that look best suited to the post
COVID economy, these are expected to thrive and those that don’t will fall by the wayside. Markets feel that this is not necessarily a bad thing and that a healthy economy always goes through periods of depression, with badly run companies failing, replaced by those better suited to the underlying situation. This has happened throughout economic history as new technology has replaced old and inefficiencies addressed.
What is undoubtedly true is that COVID has accelerated this process to a quite incredible degree. An optimist might even suggest that following a 10 year period of expansion we were overdue a recession (they tend to occur every 7 years or so) and if you cast your mind back over the last couple of years we definitely seemed to be in the very late stage of the economic cycle. COVID, they may argue, brought an economic shock that has tipped us into this overdue recession and, being event driven, this could be a shorter, albeit sharper, period of pain than that caused by a cyclical event.
To take a perhaps more controversial view, it may even be that this is the new norm and extreme intervention will continue which would, of course, give stock markets plenty of scope to rise further. Japan has been stuck in a rut of low growth and low to negative interest rates for around 20 years and, despite efforts such the recent so called “Abenomics”, they just cannot break this cycle. It maybe that as long as the music keeps playing asset values will continue to go up, but if it stops there’s going to be a mad rush to grab one of the chairs.