Posted On Saturday, Jun 13, 2020
Equity markets appear to be resilient in the midst of an economic crisis. Most investors are surprised and confused. But do you also feel a sense of Deja vu? I am referring to the years leading to 2019 when we saw similarly elevated equity prices despite poor growth. We all know how that ended. But for now, let's revisit how it all started.
Global central banks, led by the Federal Reserve adopted a twin approach to avert a recession in 2008- aggressive rate cuts and quantitative easing (QE). Once QE achieved its objective of reviving growth, the Fed began trimming down its balance sheet and increasing rates from 2015.The ECB and the BOJ however, couldn’t replicate the Fed’s moves due to muted growth and soft inflation in their respective economies.
The US economy was in a better position compared to its peers. However, it was nowhere close to long term normalized growth rates and was disconnected from financial markets. Financial markets had increasingly become the symbol of an economy’s health. The Fed became pressured into taking a policy U-turn following the financial market taper tantrum. It began cutting rates again in June 2019 and resumed QE in September of last year.
This failed attempt to normalize policy set off a fresh equity rally in 2019 that was again disconnected from fundamentals. This was a time when most economies were tackling slowing growth. The rally instead thrived on investor confidence about the possibility of never-ending central bank support. Until, it snapped in March. Yes, the Covid-19 pandemic might have been the trigger for this market crash, but there is no doubt that economic weaknesses like excessive debt levels and unsustainable asset prices, magnified by easy money-driven speculative positions, already existed.
Cut to now, unprecedented stimulus measures and near-zero interest rates to counter the economic effects of the pandemic, have again begun to fund speculative positions across asset classes as investors hunt for higher yields. Equities have surged as investors look beyond dire economic readings, focus on central bank stimulus and are optimistic about a V-shaped economic recovery.
Yes, the rebound may initially seem V- shaped given the sharp deterioration in economic activity, but won’t be a sustainable one. Printing money might prop up financial markets for the time being, but it can do very little to generate real wealth or make good the economic destruction caused by the stringent lockdowns.
There are millions of people who have lost their income sources and have been able to cope just because of the handouts from governments and central banks. Once the freebies end and things open up, not many of these will get their incomes back soon. Also, as long as people are scared of the disease and uncertain about their economic prospects, it looks unlikely that they will get back to spending like they did prior to the pandemic. Businesses too will be nervous about restarting normal operations and rehiring.
A decline in real wealth, increase in debt and less income to support are the ground economic realities. A quick rebound in economic activity therefore seems unlikely in the near future.
We have been witnessing the “don’t fight the central banks” liquidity-driven rally in equity markets, in a bid to cushion the economic impact of the pandemic. This isn’t backed by real economic growth and thus requires investor caution. This monetary and fiscal stimulus gives the markets a mere sugar high which will wear off sooner or later. The stage could thus be getting set for another market crash.
These are uncertain times and consequently heightened risk. One can now consider diversifying their positions in equities by allocating to gold. Gold has historically had low correlation to equities. So, do allocate 10-15% of your portfolio to gold, if you haven't already.
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