MIND THE GAP BETWEEN MARKETS AND THE REAL ECONOMY / THE FINANCIAL TIMES THE LONG VIEW

Mind the gap between the markets and the real economy

‘Don’t fight the Fed’ maxim requires investors to ignore the pain of consumers and firms

Michael Mackenzie


The real economy is deteriorating, with the number of US claims for unemployment insurance rising beyond 22m in the past month alone © AFP via Getty Images


The past couple of weeks have revealed the stark divide between sentiment in financial markets and economic conditions on the ground.Central banks, led by the US Federal Reserve, have pulled a series of levers intended to stop the coronavirus-induced economic downturn triggering a wider reckoning for a global financial system awash with debt.

The US central bank has even pledged to buy riskier credit, helping to lessen the pain for companies that borrowed excessively during the good times — and their owners, such as private equity firms.

For Wall Street, such actions suggest the worst is behind us, and stocks have rallied accordingly.

BlackRock, the $6.5tn-in-assets fund manager, recently said it would follow central banks in developed markets “by purchasing what they’re purchasing, and assets that rhyme with those”.

The fund manager is also advising the Fed as the central bank expands further into markets where BlackRock operates.

Similar refrains have resounded from investment houses over the past couple of weeks, prompting analysts to increase their forecasts for equity indices over the coming year.

Fighting central banks is futile, according to the consensus view, and corporate earnings will recover in 2021 after a bruising 2020.

Meanwhile, the real economy is deteriorating.

The number of US claims for unemployment insurance has risen beyond 22m in the past month alone, in effect erasing all the jobs created during the past decade.

US retail sales and industrial production both collapsed in March.

Stuck-at-home consumers, some facing salary cuts if not losing work altogether, have stopped spending much beyond groceries.

That suggests the economic damage has yet to peak.

Many worry that inflation will be the ultimate consequence of aggressive stimulus. But the near-term danger is deflation.

The Fed’s survey of regions, called the Beige Book, said the economic outlook “calls for further downward pressure on prices on average”.

This reading chimes with the dramatic slide in oil prices, which the largest supply-cuts deal in
history has not been able to reverse. Investors looking well beyond this year may take comfort from the latest IMF forecast of a rebound in growth in 2021 to the tune of 5.8 per cent.

But this is based on a few assumptions: that there will be no second or third waves of the virus; that economic activity will resume in the coming months; and that global fiscal and monetary stimulus will lay a foundation for the next business cycle.

But even after a recovery next year, the IMF forecasts a $9tn cumulative loss to global gross domestic product during 2020 and 2021, estimating that leading western economies will end up around 5 per cent smaller. Analysts at BCA Research expect muted inflation pressures for the next few years as central banks “maintain very accommodative monetary policies”.

The infusion of such liquidity “should prop stocks significantly higher as multiples rise”, according to BCA.Investors need to assess, then, whether the divergence between financial markets and the state of the broader economy implies too much faith in support from central banks and governments.

The scale of the official response highlights just how vulnerable the financial system has become after a decade of boosting returns by raising leverage.

Ultimately, policymakers are unlikely to be able to hold back a wave of defaults and rating downgrades that create further turmoil in credit markets. A period of deflation will exacerbate the problems facing debt-laden companies, particularly small and medium-sized enterprises, as the real value of their borrowings increases while their cash flows come under pressure.

Lena Komileva, chief economist at G+ Economics, said the next phase of disruption “will probably extend the pain of real-economy deleveraging and financial capital repair, after a decade of low productivity, low yields and high leverage”.

For all the cheerleading from Wall Street, the internal signals from markets are not exactly comforting.

Financials have notably lagged behind healthcare stocks, reflecting anxiety about the economy.

But what really sticks out is the narrow leadership within the benchmark S&P 500 stock index, which favours the tech titans.

Strip out ecommerce giant Amazon — which hit a record high this week — from the consumer discretionary sector, and a loss of 14 per cent so far this year becomes a decline of around one-fifth.Market sentiment often runs well ahead of outcomes.

At this juncture, the broad performance of equity and credit suggests that long-term trends in sales and profits for many companies will remain intact.

The danger is that the pandemic-induced recession and the pain registering across the real economy has yet to really test a leveraged financial system.

Hence the speedy and unprecedented actions from the Fed.But these alone cannot patch holes in economies.

As Ms Komileva puts it: “The optics of cheap Fed leverage fuelling capital market bargain-hunting do not equal real economy profitability or job creation.”