Market rally is based on optimistic assumptions

On both sides of the Atlantic, brokerages reported a sharp rise in customers opening accounts to buy shares after lockdowns were imposed. Whether this was a symptom of optimism, boredom or households having cash they would otherwise spend on the daily commute, eating out, or gambling, retail investors have helped to drive a stock market rally across the rich world. Investors may be right in the end, but they should take account of the fragile assumptions underpinning the recovery in equities.

The S&P 500, the main US index, has recovered most of its losses since the coronavirus began, and now sits only about 10 per cent below the pre-crisis peak in February. The recovery, originally led by tech stocks, has now broadened to encompass a wider range of sectors: financials, industrials and real estate have all been strong performers over the past week. An unexpectedly bold EU recovery plan has also helped European assets; the euro has reached its strongest level against the dollar since April.

Seemingly ebullient markets stand in contrast, unfortunately, to bleak economic news, such as the announcement on Thursday that 40m Americans have now registered for unemployment benefits since the start of the crisis, or that carmaker Renault will make 14,600 staff redundant.

For many this dissonance is further evidence that over-optimistic markets are getting ahead of themselves in the belief that a vaccine, or at least new treatments, will curtail the coronavirus pandemic and the economic damage wrought by lockdowns.

The rise in equities, however, must be seen in light of the protection and stimulus policies launched by governments and central banks. As interest rates fall, asset prices rise. Many investors are betting that, with inflation a seemingly distant prospect, central banks will keep rates at record lows into the distant future — or at least that rates will rise only in concert with higher, sustained, economic growth. This gives even fundamentally pessimistic investors good reason to buy into the rally.

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For others, the decision to buy shares reflects their fiduciary duties. Asset managers are not paid for holding their clients’ money in cash. With a choice between keeping funds in a zero- or even negative-yielding asset and one with even a modest positive yield they are under pressure to buy shares.

Risks remain, though. Bad news post-lockdown or a potential second wave of infections in rich countries could see asset values plummet. While European countries and the US are relaxing restrictions on businesses, virus cases are rising in middle-income countries such as Brazil, Mexico and Indonesia. Rising inflation, too, would undermine assumptions behind the rally — though this seems a distant prospect: data on Friday suggested the eurozone is on the verge of deflation. The banks have been mercifully isolated from any contagion so far, but a crisis in commercial real estate, corporate or consumer lending could change that and also call into question the ability of central banks to contain matters.

Tensions between China and the US are already unsettling markets: risk assets fell on Friday as President Donald Trump prepared to respond to Beijing’s move to impose a national security law on Hong Kong, and China threatened “countermeasures”.

Either way, the global economy is only in the first stages of an economic downturn; there will be many twists and turns in the path markets take. Equities’ current valuations are plausible — but only if the most optimistic assumptions turn out to be accurate.



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