why are markets so calm

One of the more challenging conversations that I am having with clients at the moment is trying to explain why stock markets have been so resilient during recent weeks in the face of such seismic economic disruption.

The Bank of England suggested at the beginning of May that UK GDP, the benchmark reading of the country’s economic growth, could fall by 14% during 2020. If this comes to pass it will be the worst fall since 1706. In the same statement, the central bank suggested that unemployment could exceed 8% by the end of the year. These figures may come as no surprise given the situation that we find ourselves in, but they are still a stark reminder of today’s unusual circumstances. Each day seems to bring a fresh and unwelcome record for some long-running economic data point.

Nonetheless, to the end of the first week in May this year, the FTSE 100 index had returned just shy of 19% since its low on 23 March. Global shares went a percentage point better, returning close to 20%. Squaring off this strong performance alongside a global economy that has effectively ground to a halt is a real challenge. Before I set out my thoughts, however, a caveat; it is impossible for anyone to look at the behaviour of such a vast entity as the global stock market and say with any degree of certainty what is driving asset prices in real-time. The market encompasses so many separate moving parts that it may be many years before it becomes clear(er) what the main factors at play are here.

Remember markets are forward looking

I do think that the current period provides a clear reminder of what stock markets are and are not. Markets represent the aggregate opinion of global investors as to what the future will look like. As markets work every day to price in expectations for future corporate earnings and growth, they do not reflect the current economic situation. This forward-looking nature may explain why we see such counter-intuitive share price moves in the face of seemingly catastrophic news.

For example, on 26 March it was announced early in the trading session that 3.3 million Americans had filed for unemployment benefit the week before, a record at the time by a significant order of magnitude. US shares reacted by closing higher. A week later, on 3 April, the unemployment number was even worse (6.6 million) and again the market closed higher, up 2.3%.

It seems that instead of being surprised by these figures, investors had expected this brutal slowdown and had arguably already priced in the effects of a still worse situation. Even as it became clear that the coronavirus pandemic had unwound all of the job gains in the US from the past decade, US stocks still managed to recover around half of their brutal February/March falls.

It might appear crazy for US shares to have moved back up, but this can be explained by the fact that investors are effectively ignoring 2020 and instead focusing on 2021. Investors value a company on the basis of its future cash flows. If there is an aberration one year – say from a global pandemic – but future years look set to return to normal, investors can temporarily look through the bad year and anticipate all those profits coming back to them further down the line.

Learning the lessons of 2008

Meanwhile, the current resilience in stock markets is even more extraordinary in the context of history. During past recessions markets have usually underperformed during the worst of the economic fall-out. In the global financial crisis during 2008 and 2009, for example, the FTSE 100 index was all but cut in half at the worst point, while the global economy contracted by a relatively meagre 6% between the first quarter of 2008 and the second quarter of 2009.

Again, however, I feel that there are important distinctions between the current crisis and those of the past. The situation today is arguably far clearer than it was just over ten years ago. We not only know what has caused the current financial disruption, but have chosen as a society to accept recession as the price for protecting against the worst of the public health crisis. We have taken the view that short-term pain today will lead to a better medium-term outcome.

In contrast, during the depths of the 2008/09 global financial crisis it was difficult to tell where the next piece of catastrophic news would come from and how big of a systemic risk we faced in terms of the potential collapse of an entire financial market or system.

We also need to consider the swift and unprecedented nature of central banks’ and governments’ responses to the current crisis, as well as the relative stability of commercial banks today. This explains why it is easier to conclude that we are in a better position to deal with today’s problems than we were with those of just over a decade ago. In some ways, governments and central banks have taken the lessons from recent history to heart, and many are now model pupils. The current broad investor optimism appears to reflect this.

Calm on the surface

In contrast, during the depths of the 2008/09 global financial crisis it was difficult to tell where the next piece of catastrophic news would come from and how big of a systemic risk we faced in terms of the potential collapse of an entire financial market or system.

The chart below shows significant outperformance for higher quality companies in steady or growing sectors – such as healthcare and technology – versus more cyclical names in the financial and industrials spaces, which are more sensitive to changes in the economic cycle. Taking another example, no-one could look at the share price performance of the airlines or cruise operators since the beginning of 2020 and suggest that these sectors have been unaffected by the crisis. 

Similarly, we have seen large dispersions in terms of returns from geographic markets – with US stocks continuing to outperform and following a consistent theme from recent years. This is partly due to a large exposure to technology stocks within the stock market index, which have performed well during the market falls. But I sense it is also potentially driven by the rather less stringent ‘lockdown’ and social distancing measures that have been seen across large sections of the US. Less economic disruption should in theory mean more resilient share prices – albeit there are again certain sectors which have undoubtedly experienced greater pain than others.

However, this dispersion not only creates opportunity, but also reminds us of the importance of looking for the highest quality companies available for investment.

In many ways this crisis has provided us with the ultimate ‘stress test’ for companies, with stable and organically growing businesses best placed to cope. As we look to come out the other side of this crisis, there will likely be a clear divide between those companies that have succumbed to the current pressure, and those that are expected to increase market share and embed their positions further. Understanding these trends and market drivers will be key to investors being able to take advantage of the opportunities that arise as economies and stock markets recover.

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