Common sense foundations behind rapid market recovery
Speed of rally in stocks is breathtaking but causes are strikingly simple
Robin Wigglesworth
US stocks have led the market recovery, with the S&P 500 last week touching a record high © AFP/Getty Images
The hottest finance industry topic is the extraordinary market recovery from the Covid-19 shock, what is causing it, whether it is durable, and what the consequences are.
It is worth taking a moment to marvel at just how powerful the rally has been. Global equities have already clawed back almost all the losses suffered in one of the biggest and certainly the swiftest collapses on record, and earlier this month went back into positive territory for the year.
US stocks have been the stars of the show, with the S&P 500 last week touching a new record high, despite unemployment still being near post-second world war peaks. Contrast this to the four years it took for equities to recover from the global financial crisis of 2008.
The aggressive response of central banks is often credited for the strength of the rally. Add to that a robust fiscal response by governments, and the so far largely successful end of lockdowns in many leading economies, and you had the ingredients for a strong recovery, especially in the US, where the market is dominated by a handful of technology behemoths that benefit from the Covid-19 disruptions.
But these factors are only part of the equation and cannot entirely explain just how far and fast markets have rallied. To understand this, we need to look at the biggest, least-appreciated change from a decade ago: Investor expectations.
When the financial system stabilised in 2009, the debate was largely around when interest rates would be “normalised” and bond yields would climb back to pre-crisis levels. Some thought it might take a year or two, while others reckoned “lower for longer” was the most likely scenario. Any disagreement was largely around timing.
Today, the “lower for longer” view has morphed into “low forever”. A decade ago, betting against bonds was almost fashionable. Today, the trendy trade is to bet on yields never rising again. Some investors now think above-inflation Treasury yields is something they will wistfully tell their incredulous grandchildren about.
The best evidence is the 10-year, 10-year Treasury forward, a futures contract that shows what investors think the 10-year Treasury yield will be in a decade’s time. It provides a distilled, clean(ish) measure of investors’ long-term expectations for the world’s most influential interest rate.
In 2009, the 10-year, 10-year forward yield rose from 3 per cent to north of 5 per cent, as investors bet on prices falling in a great “normalisation”. From 2010, it haltingly ground lower again. But this year the 10y10y measure has collapsed to just 1.6 per cent. In other words, investors expect Treasury yields to remain well below the Federal Reserve’s inflation target for at least the next decade — and likely longer.
The new thesis can also be seen in bank stocks, which typically benefit from rising interest rates. Back in 2009, bank stocks recovered more quickly than the broader equity market, as investors bet that survivors would grow stronger from the calamity and emergency stimulus would eventually end. Warren Buffett, in particular, made a fortune from big, daring wagers on financial stocks in the depths of the crisis.
In sharp contrast, banks have lagged far behind this year’s stock market rally and the “Oracle of Omaha” is now dumping bank stakes rather than amassing them.
The decline in long-term interest rate expectations does not explain everything, of course.
Japanese bond yields have been similarly depressed for years without any meaningful impact on equity valuations there. And it is inherently risky to make long-term investment decisions based on an indicator that has proven faulty in the past.
After all, exactly a decade ago, the futures contract suggested that the 10-year Treasury yield would be 4.5 per cent today. Instead, it is 0.6 per cent. Investors could obviously be wrong again, albeit the other way around this time. The strength of the current “low forever” consensus does feel a tad overdone and it will surely be tempting for some contrarian investors to take the other side at some point.
However, for the foreseeable future it is hard to envisage high-grade bond yields moving meaningfully higher. The secular, broad-based decline in economic vigour and the weight of global debt means that any serious increase in yields would likely be countered by even more central bank stimulus.
That has huge consequences for the entire finance industry, whether pension funds desperate to know where they can eke out returns, or banks dourly looking at their loan books. And when investors are in practice anticipating that money will in real, inflation-adjusted terms be free for at least the next decade, what would be considered a fair price for all other financial assets inevitably has to be revisited.
Perhaps the other topic for those oddly financially-savvy grandchildren will be why equities were ever so cheap.
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