Despite all of the economic harm caused by covid, the major global stock markets are miraculously near to or above their pre-covid level.
Had this not been the case our pensions and savings would have been seriously harmed, adding to our woes, so what’s not to like? In this blog, I will discuss why stock markets might be defying gravity, and why this has deleterious consequences.
Before the crisis, many commentators thought that many equity markets, in particular those in the USA, were overvalued, for example by comparing current prices to historical price/earnings ratios. Then came coronavirus – a shock which could have not be anticipated and therefore was not priced into asset prices.
On the face of it, the economy is in a far worse state than previously, when these markets were already over-valued. There is likely to be a wave of bankruptcies, governments have taken on a whole lot of new debt, economic activity is much lower than it was before the crisis and will take an indeterminate amount of time to recover. In the meantime, the number of covid-19 cases globally and in the USA is increasing, meaning that there may be more lockdowns and negative economic shocks.
To a layman, you would expect equity markets to be well below their pre-crisis levels, so why are they at around the same level or higher? Unfortunately, you can’t ask the market, and there is no single right answer, but here are some suggestions as to why they are defying gravity:
- Tech stocks: the S&P500; the main US equity market indicator is disproportionately dominated by tech stocks. These have had a “very good crisis” as people switch to home working, shopping on Amazon and watching Netflix.
- Equity markets are forward looking: the price of an equity stock is based on future earnings, the markets are expecting future activity to pick up, so what is happening now is of lesser importance.
- The interest rate: the value of a stock is the discounted value of future income, inversely proportional to interest rates; and we are currently in a very low interest rate environment.
- Wall of liquidity: there is a huge amount of money looking for investments, which has to invest somewhere. If it sits in cash or bonds it earns virtually nothing as interest rates are close to zero or negative, so it invests in equity for a lack of alternatives, pushing up the price of equity.
- Government intervention: central banks and treasuries are buying up financial assets on a vast scale, boosting the price of securities. There is a belief that governments will continue to intervene should prices reduce, limiting investors’ downside risk.
Some may quibble about any one of these points, but I think in aggregate they provide an uncontroversial explanation of the high equity prices.
So why is the high equity price a problem? After all, our savings and pensions are boosted by this, pension funds in particular would be facing solvency problems with much lower equity levels, which would add to our problems.
My suspicion is that the disconnect between equity prices and the “real economy” is deeply problematic for a number of reasons:
- Many commentators observe that the market is anticipating a rapid V shaped recovery. This may happen, but I think it’s unlikely, and the possibility that the rapid recovery won’t happen is not being priced into the market. If there is a Minsky moment when investors think the V-shape won’t happen, the market will rapidly correct. This correction, otherwise known as a crash, could have severe consequences on both the financial and real economies.
- Inequality: most people have no savings and most financial assets are owned by the wealthiest so, if financial assets increase in value in relation to the rest of the economy, this increase inequality.
- Aligned to B, we get further political fall-out; with most of the population suffering whilst the rich get richer.
- Also aligned to B, because of the success of big-tech, we get an even greater increase in power of a few corporations such as Google and Amazon.
- Misallocation resource and zombie companies: if asset prices are inflated above their economic value, economic actors will make wrong allocations. A case in point is Hertz, the car rental company, which has a soaring stock price even though bankrupt.
- Further bail outs: central banks and governments have used up all their policy ammo already; like drug dependency the more intervention there has been the less effective it becomes. Bail-outs lead to further adverse consequences, mis-allocation of resources, ability of financial actors to game and inevitably favour the wealthiest.
- Blow out of debt: high stock market valuations, low interest rates encourage even more resulting in even less resilience.
- Financialisation of economy: the high level of debt and value of financial result in the further financialisation of the economy, which beyond a certain size – which has long been passed – becomes mainly a rent extraction activity.
Ultimately the cause of much of the stock markets being high – reasons 3-5 above – are down to actions of governments and central banks, which are pumping money into financial markets and keeping interest rates low.
They have effectively been doing this to a greater and lesser extent since the last financial crisis 12 years ago, which has resulted in financialisation of the economy, high debt levels, obscene levels of inequality, the rise of populism in reaction and a general lack of resilience in the economy, the finance sector and society.
It is understandable that governments and central banks have chosen this course to deal with temporary shocks and short-term problems. But the short -term problems are continual and temporary shocks recur frequently.
What to do? Financial policy needs to re-focus on the real economy, too much financialisation and debt are a bad thing and need to be actively reduced, as does the level of inequality.
Bail-outs should be directed at the lowest paid, small business and citizen first, big business and the financial markets last if at all. There are a lot of practical ideas have developed over the years, based on heterodox economics, these need to be considered and implemented – and fast.