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.
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.
This does mean that US stock markets look expensive if you look at what companies are earning today, but then the stock market is a forward-looking indicator, not a real-time measure of economic health. And of course there is always the potential for markets to change their mind about what 2021 looks like further down the line.