Written by Hudson Adviser Phillip McGann
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The news out there is bleak. The virus is on a tear around the world. Melbourne has gone back into lockdown. The government budget is heavily in the red, unemployment is high, the economy has entered its worst recession since 1992.
And yet world share markets are on the rise.
Something is wrong with this equation.
When the real economy is tanking why do financial markets seem to be ignoring this and continuing to rise?
The answer is both simple and complicated, in equal measures, but in reality boils down to three major points:
- Fundamental attribute of share markets being a forward looking indicator
- Massive fiscal and monetary stimulus to economies
- Investor psychology leading to FOMO
SHARE INVESTING FUNDAMENTALS
Fundamentally share markets are forward looking indicators of economic activity. Share investors are looking 12 to 18 months into the future to see both what the economy will bring and how it will impact individual companies prospects look overtime.
Investors don't really care what happened yesterday or what a company has done up till now. They are fundamentally focused on prospects going forward.
On an economy wide level share prices give a very good barometer of the mood of investors as they are immediate and very liquid investments.
If the economic outlook as a whole is poor the market as a whole will be sold down as investors retreat from risk assets.
If conversely things are likely to be buoyant going forward, or there is anticipation this will be the case in the near term then investors will drive prices higher to reflect the new "future" value of the share market due to these favourable conditions flowing through to likely higher business profits in coming years.
This is how share markets operate and this is how markets are operating now.
Yes, there is a flow of bad news presently with virus cases continuing to rise around the world and locally but look a little deeper and you see a lot more hope than is being portrayed in the media.
Death rates are lower even as cases rise due to better treatment and a younger healthier lower risk age bracket catching the virus.
Hopes of a vaccine are on the rise with well over 100 vaccine candidates under research around the globe and half a dozen of those in human trials right now; including one from the University of Qld. Initial results are proving promising and accelerated development is leading to a contraction in the likely time frame of a vaccine release down from the traditional 3 to 5 years to potentially next year.
Case loads in countries that caught the virus early are receding. Major outbreaks in Italy and Spain from a few months ago are a lot lower now as lockdowns have had the desired effect and a change in people behaviours pays dividends.
Economic activity has been crushed and the OECD has forecast the first world wide substantial drop in GDP since WW2.
However we appear on many parameters to have seen the worst of the economic slide and the major economies are showing signs of "bottoming out" with activity beginning to improve.
The share market looks at these figures and using its "forward looking prism" decides collectively that the worst is past and now is a good time to buy shares.
FISCAL and MONETARY SUPORT in SPADES
At the recent low point for shares in late March the US central bank - the Federal Reserve - lead the world in declaring that it will do "whatever it takes" to keep the US economy afloat.
It has open up the floodgates and sprayed cash in every direction.
With interest rates at historical lows of near zero the traditional route of rate cutting to stimulate the economy was not available so the Fed went further and entered into the debt markets to buy securities with the idea of keeping rates low and liquidity buoyant
The Fed announced it was open for business, it has said it will "buy anything" the market will sell. This includes all Federal government debt and state government debt and municipal debt and corporate debt and junk debt.
By doing this it avoided the pitfalls of the GFC in 2008 when the credit markets seized up for a time hampering the real economies recovery. The Fed learnt from this and its actions as a "buyer of last resort" has given massive confidence to the markets and led to a relatively stable market for corporate debt so they can actually refinance their debt levels and stay afloat as they await recovery in the real economy
Central banks around the world including the RBA have followed suit and pumped massive , even unprecedented amounts of funds into there economies via the debt markets ensuring companies stay afloat as there cash flows dry up and interest rates remain extremely low.
On the fiscal front governments around the world have also opened up their wallets (funded by central bank purchases of their bonds) and lavished cash on their populations.
Whether it is direct individual cheques in the US or increased welfare payments and JobKeeper in the local economy the idea is to keep the economy functioning, keep business open and employees engaged as much as possible until the economy can reopen fully.
Share markets reacted very favourable to this government largesse as it underpins the economy and makes a worst case scenario less likely.
An added impetus is that lower interest rates globally mean bonds and fixed interest investments (even money in the bank) are relatively less attractive to investors than shares.
Fear of Missing Out
Psychology of investors is very important in share markets. Fear and Greed are the two basic emotions and in early March Fear of an unknown pandemic took over and share investors disappeared "under the doona."
Since then those same investors have seen the braver amongst them dive back into the markets at the lower levels.
When coupled with the massive Fiscal and Monetary stimulus as well as medical updates they have now decided that maybe, just maybe, shares are the way to go at these levels.
Investors who have seen shares rise at a rapid rate are now jumping back in for fear of missing out.
So does this mean that the share market will continue to power along from here and have no handbrakes to future rises? No, not at all, as we have seen uncertainties in all for all of these scenarios and we will likely have more volatility from here.
Now the virus figures could roll over and get worse.
The virus could come back in second and third waves (as we are seeing in Melbourne currently as well as in parts of Spain) and the share market may be wrong and it may well retreat as investors digest new information.
However over recent months the figures coming out appear to suggest the worst is over economically and the recovery has begun and share investors have dived in at the lower levels
But the fundamentals are still there to support the markets with lower interest rates for many years to come and continuing government support for economies.
The underlying issue is - as it has always been - the virus.
If we can get in control of the virus either via an effective vaccine, better treatments, herd immunity or simply learning to live and operate society and our economy with it in our midst this will go a long way to providing comfort for investors from here. If we cannot the volatility may return.