UK Economic Outlook: It was the best of times, it was the worst of times
First, let’s put this discussion into context. The MSCI world rose 34% between the low point on 20th March and the end of May, and the tech heavy NASDAQ index was only 3% off its all-time high. U.S. high yield debt spreads versus treasuries had come in from over 10% to 6.5%, and there had also been declines in European and UK spreads, though not of the same magnitude. Meanwhile analysts are having to rescale charts to cope with the amount of unemployment claims in the US with one widely watched measure of employment falling by 20m in a month. Global activity measures have reached depths not even plumbed in the financial crisis, and estimates for quarterly GDP normally given to 1 decimal place will be considered good if they are within 5% of the actual fall. How can both of these things be happening at once?
The first thing to note is that the equity market and the economy are not the same thing. Markets are emotionless discounting machines always looking forward, they care nothing for the present or the past. Equity markets are concerned only about the net present value of future dividends, not today’s unemployment numbers; debt markets are only worried about whether companies can meet their obligations in the future rather than any economic activity index. As long as the future is expected to be better than the present, or more precisely, as long as expectations about the future keep on getting better, equity markets will rise. Thus, the best time to purchase equites is when current circumstances are poor, but when there is light at the end of the tunnel.
There are two other related reasons why markets and the real economy are diverging. Firstly, central bank action and fiscal stimulus have led to ample liquidity. Historically this liquidity has found its way into risky assets such as equities, and it seems the same is occurring on this occasion. Related to this, central banks are directly buying risky securities as well as government bonds. The Bank of England and European Central Bank are buying government debt and investment grade credit, the Federal Reserve is buying both of these asset classes as well as high yield debt. The Bank of Japan is even buying equities. Even if central banks are not directly purchasing equities, their purchase of other assets forces the price of those assets up and makes equity valuations seem cheaper in relative terms. In turn, this then encourages investors to invest in equities.
Finally, the increase in equities is a direct consequence of the way investors value equities. In theory, the price of a share should be the net present value of future dividends. In order to arrive at this value we need an estimate of future dividends as well as a discount factor. This discount factor is made up of the long-term risk free rate from government bonds and a spread to make up for the fact that equities are riskier than government bonds. As the economy contracts, long-dated government yields typically fall as central banks reduce policy rates and undertake bond purchases. Other things being equal, this will lead directly to a rise in equity valuations. Of course other things are generally not equal, and it is entirely likely that expected dividends will fall as the economy contracts, and the premium required for holding equities will rise, pushing valuations lower. However, market participants have recently started to revise up dividend estimates, and the riskiness of holding equities as measured by their volatility has fallen. Long term interest rates however remain low, and thus, equity valuations have rebounded.
From an investors’ perspective, it is vital to separate ‘The Economy’ from ‘The Markets’. Trying to time markets or being too active can lead to missing out on valuable returns. This is why we always set our strategies for the long term but also try to rely on asset classes that have long term, predictable cashflows rather than more volatile equity markets.