One feature of 2020 is a disconnect between stock market performance and the hit experienced by the global economy. Despite the Covid-19 pandemic denting GDP almost every country around the world, major stockmarket indices are flirting with record highs.
Yesterday in the United States, President Donald Trump withdrew his threat to obstruct a $2.3 trillion government spending and coronavirus relief package, sending global stock markets to even higher levels.
Markets were also helped higher during their first post-Christmas by the news on Christmas Eve that the United Kingdom and European Union have agreed on a Brexit trade deal. The relief experienced by investors following this news pushed US stock indices to intra-day record highs, and the Dax index in Germany reached its highest ever level.
But can these record stock market levels be sustained against a backdrop of economic uncertainty and rising levels of government indebtedness?
By the end of this video, I’m going to reveal the factors pushing stock markets to record highs and answer that all-important question; can they keep on going like this?
It’s been a strong start to the week for global stock markets, with traders returning from their Christmas break to a couple of good news stories.
First was the announcement on Christmas Eve that the UK and EU have agreed on a trade deal, coming into force when the Brexit transition period ends on 1st January.
We often talk about good news like this being priced into the markets, but, on this occasion, I honestly don’t believe that the markets were convinced. At best, there was a 50/50 chance of a no-deal Brexit, with the UK and EU reverting to World Trade Organisation trading terms, with the associated tariffs and customs checks.
The trade deal is awaiting UK parliamentary approval on Wednesday, with a very minor risk of failing to secure enough votes from MPs. The European Parliament won’t vote until the New Year, but Ambassadors for the European Union’s 27 member states have unanimously approved the provisional application of the trade deal.
So, good news on the trade deal driving markets higher, as well as Trump stepping aside and belatedly agreeing to sign off on the $900bn worth of Covid relief, and $1.4 trillion of government spending.
The Covid relief and government spending bill takes the US through until the end of next September and was at risk of delay after Trump wanted the level of spending scaled back, but increasing the level of household support from $600 to $2,000 per person.
If Trump had stuck to his guns, it would have resulted in a shutdown in parts of the state infrastructure and a continued freeze for unemployment benefits for millions of people.
I think there’s one other good news story that helped to push markets to record highs at the start of this week, and that’s the pending approval of the Oxford/Astrazeneca vaccine.
Pascal Soriot, chief executive of AstraZeneca, speaking to the Sunday Times, said: “We think we have figured out the winning formula and how to get efficacy that, after two doses, is up there with everybody else.” That statement suggests the efficacy of around 95% and it’s also apparently 100% effective in preventing severe illness requiring hospital treatment.
The Oxford/Astrazeneca jab is great news for several reasons; it’s cheap, at around £3 a dose. It doesn’t need the same ultra-cold storage required by the Pfizer/BioNTech vaccine, and the UK government has already placed an order for 100 million doses.
This vaccine, along with the others, could quickly unlock the UK economy and get things back to some sort of normal. It’s little surprise that the markets are responding positively to that.
Of course, the Brexit trade deal, Trump allowing stimulus through, and the AstraZeneca vaccine news is all short-term news. It’s good news for the markets this week. But it’s not what’s pushing them to their record highs. To find the answer to that puzzle, we need to look at low interest rates.
Interest rates are incredibly low right now because central banks are printing money to buy up stocks of government bonds; a process known as quantitative easing or QE. This massive money printing process drives up the price of bonds, government debt, and bond prices have an inverse relationship with bond yields – higher bond prices mean lower bond yields, or lower interest rates.
But what do low interest rates have to do with high stock market levels?
Equity valuations get a hefty boost when interest rates are so low, because these low interest rates are used to discount back future profits.
QE is also pushing up the supply of money. Some of that extra cash has found a home in the stock market. Looking back at history, when money supply increases, so does the level of the stock market. They fairly reliably move in tandem with each other.
But, I hear you say, how can the stock market race ahead when the global economy is doing so badly? And it’s a fair question.
Covid has hit the economy hard; here in the UK, but also across Europe and in the United States. Unemployment levels are high and rising. Unemployment in the UK is forecast to reach 2.6 million people by the middle of next year; that’s 7.5% of the working age population. More people out of work means fewer people buying goods and services, and you would reasonably expect compay profits to fall accordingly.
What we need to remember here, as departed from logic as it seems, is that the economy and stock markets are rarely well correlated. Looking back to the end of the Second World War, stock markets rose in seven of the past 12 economic recessions, rising on average by 5.7%.
There’s no guarantee that markets will continue to rise in the next year or two.
Over the long term, we would expect stock markets to reward patient investors. In the short term, volatility and market corrections are a feature, not a bug, of stock markets.
Corrections happen, and when they happen, recoveries typically follow quickly. Investors who lose out when stock markets fall sharply are those that panic and take their chips off the table at the wrong time.
I do have concerns about longer-term structural issues surrounding the end of QE and its ultimate reversal. There are big questions for central banks, governments and economists to answer about how that pans out, and the impact it has for investors. But that’s, quite frankly, a tomorrow problem.
Another concern that plays on my mind an awful lot, as someone responsible for allocating half a billion pounds of investor capital (half a billion pounds sounds a lot better than £500 million, doesn’t it?!), is the concentration of stock market value in a relatively small number of companies.
There’s a problem when the value of one stock, Apple, exceeds the total market capitalisation of the entire FTSE 100 index of leading UK company shares.
There’s a problem when the five largest tech companies in the S&P 500 index represent around a quarter of its market capitalisation.
Each time in the past that a single sector has represented more than a fifth of the S&P 500, its ended badly; energy in the early 80s, tech in the late 90s, and financials in the mid-2000s. We would be crazy if we failed to learn the lessons from history.
As an investor, it’s too easy to convince ourselves that, somehow, this time it might be different.
I know I bang on all of the time about the importance of diversification, but never in my 20-year career in financial planning has it been more important than I believe it is today. Concentrating your portfolio in a handful of sectors or stocks, whether intentionally or not, is a mistake that will ultimately punish you as an investor.
Markets can keep rising in 2021. They don’t necessarily need an early and significant economic unlocking event for that to happen. In fact, lockdown measures could continue throughout most of next year and the markets could independently rise. I’m not suggesting that’s what’s going to happen – I don’t have a crystal ball – but it’s possible.
What we need to recognise as investors is the importance of being aware of these factors driving markets higher, and what might happen next, given awareness of these factors.
Do you agree with my analysis of what’s pushing stock markets higher as 2020 draws to a close?