Important note: this article contains commentary on recent trends affecting the economy and stock markets of the United States and may not be relevant to any other jurisdiction, including Australia.
Over the past nine weeks, 36 million Americans have filed unemployment claims. US GDP plunged by 4.8% in the first quarter of 2020. Yet the US stock market surged by 13.2% in April, the largest monthly increase since 1987.
What on earth is going on? Why is the US market apparently moving in the opposite direction to the US economy?
Past performance is not a guide to future performance and may not be repeated. Source: Refinitiv Datastream and Schroders. Notes: US equities = MSCI USA Index. Data from December 1969 to April 2020.
Although this may seem unintuitive, there is, in fact, a large body of evidence which shows that there is a very weak relationship between equity returns and economic growth. You should not necessarily expect the two to move in tandem. Several factors might explain this behaviour.
Markets are forward-looking
The most important reason is that a company’s stock market value can be thought of as the present value of all its future earnings. These are related to economic growth but not on a one-to-one basis (please see below for a brief explanation of some ways they can differ). Its value usually reflects not only what is happening right now, but also what is forecast to happen next year, the year after, and so on. Stock markets are generally forward-looking.
In contrast, much economic data tells you about what has happened in the past. To give an obvious example, GDP growth figures are not released until after the quarter has ended.
This means any news that impacts profit expectations can move the market before it hits companies’ bottom lines. This is exactly what has happened this year in the US. US stocks fell by 24% in the first three months of the year in anticipation of the economic slump in the US that has subsequently been realised. A lot of bad news involving the US market appears to have been already priced in when we entered April.
Similarly, while it is easy to be fixated on the current dire situation in the US, this is not expected to continue indefinitely. As they reflect all future earnings of a company, stock prices capture both the near-term negative outlook, but also a subsequent recovery (even if the shape of that recovery is open to much debate).
For example, while analysts are forecasting earnings in the US to fall by more than 25% this year, forecasts for 2022 are only around 11% lower than they were at the start of the year. After the recent rebound, this is also relatively close to the year-to-date move in the US stock market. The two appear fairly consistent.
Past performance is not a guide to future performance and may not be repeated. Source: Refinitiv Datastream and Schroders. Data from 31st December 2019 to 5th May 2020.
As well as stock prices being forward looking, there has also been an additional catalyst which has spurred some markets higher in recent weeks. This has led to an even greater apparent disconnect between those markets and their related economies. This catalyst is the huge stimulus package that central banks and governments have unleashed.
The US Federal Reserve has slashed short-term interest rates to zero, pledged to buy government bonds in unlimited amounts, and to buy specified quantities of investment grade corporate debt and high yield exchange-traded funds.
This has been paired with a large fiscal response in the US, including the expansion of unemployment benefits, direct money transfers and loans to small businesses.
These unprecedented measures appear to have helped shore up stock prices in the US by boosting market liquidity, lowering the cost of borrowing, providing financing to corporates and raising business confidence.
Lower interest rates are also generally positive for markets because they increase the present value of future earnings that would accrue to shareholders. When this happens, stock prices tend to appreciate in value.
The stock market does not necessarily represent the real economy
Differences in the composition of the US stock market versus the US economy have also contributed to the disconnect. For example, the largest tech companies in the US – Microsoft, Amazon, Apple, Google and Facebook – have vastly outperformed the broader US market as a result of stay-at-home orders. These firms represent 20% of the S&P 500 Index, yet their combined revenues in 2019 amounted to only 4% of US GDP – 5x less.
Source: Refinitiv Datastream and Schroders. Notes: reported global revenues as at FY2019, with broker estimates used for firms yet to report earnings. Market value as at 1st May 2020.
One reason for this mismatch is that stock market indices such as the S&P 500 are weighted by the market capitalisation of their constituents. The more valuable the company, the larger the index weight. This means smaller firms tend to have little US stock market representation, even though they account for 44% of US GDP, according to a report from the US Small Business Administration Office of Advocacy.
Small businesses are likely to suffer more from the economic shutdown because they typically have smaller cash buffers to draw upon compared to larger businesses and have difficulty accessing cheap credit. Yet this adverse impact will not be proportionately captured by the stock market, as most small firms are not publicly listed and those that are will have a low index weight.
Besides sectoral differences, performance may also sometimes diverge because of varying exposure to growth overseas. For example, according to company filings data, US stocks derive around 30% of their revenue from exports, but exports only represent around 12% of US GDP. On this occasion, however, international revenue diversification is unlikely to mitigate US domestic headwinds, as nearly all countries globally have shut down their economies, to at least some extent.
Risk of a further correction is still possible
While recent moves in US stock prices and economic newsflow may seem at odds with each other, we think that they are not. The forward-looking nature of stock markets means that the US market priced in a lot of this bad news when it crashed in the first quarter of 2020. Stock prices also generally look through the near-term into how company prospects are expected to evolve over the long run – even if that is harder than usual to ascertain at present.
Central bank and government support also appears to have eased fears over some of the worst-case scenarios that markets were worrying about earlier this year. And central bank liquidity injections appear to have helped to support asset prices.
Does this mean we are out of the woods? Unlikely. Despite all the liquidity sloshing around, that may not enough to keep businesses afloat and get consumers to start shopping again. Revenues are likely to remain under pressure for the foreseeable future. Entire industries are exposed. Many companies are likely to struggle to afford debt repayments, increasing the risk of a wave of defaults and bankruptcies.
With few US companies offering earnings guidance amidst the economic uncertainty, US markets could be due another correction if things turn out to be worse than expected. After all, in the past, there have been around three “false dawns” during major equity sell-offs in the US.
It is also worth remembering that, although markets have partially recovered losses at the index level, this is not true for all sectors. Depending on their economic sensitivity to the lockdown, there are clear winners and losers emerging. The next phase could well see this trend of diverging fortunes persisting. Investors need to remain on-guard.