Return of reason or temporary hiatus? Nick Keeling

Financial assets have had a turbulent week. Risk assets have sold off significantly; the FTSE 100 closed at 6,077 on Thursday, down 6.1% since Monday’s open, the S&P 500 at 3,002, down 7.1% since Monday’s close, crude oil futures dropped down 10.4% over a similar period. Safe haven prices have been bid up to challenge previous highs; the UK 10yr gilt yield closed just below 0.20%, having hit 0.35% on Monday. A fairly brutal correction, and one that saw the VIX index spike to 40.8 from below 30.

However, while these are significant moves, it’s fair to say that risk assets have had a stellar few months since the market freefall towards the end of March. For instance, the FTSE 100 was up 30% as at last week’s close, while US equities have done even better, the S&P 500 up 36% and back in positive growth territory for the year and the Nasdaq hitting an all-time record high! That’s right, amid the most severe recession in modern history, the tech-heavy US index has not only nearly recouped all the losses from the initial sell-off but gained enough momentum to reach new heights.

And therein possibly lies the answer to the cause of the correction this week. Had investors simply got ahead of themselves or is there more to the rise than meets the eye?

There is clearly some evidence of the former. The spark for the sharp sell-off appears to be the FOMC minutes and the Chairman, Jerome Powell’s, press conference. He pointed out that monetary policy would remain and become more accommodative, because this was desperately needed; the economic downturn was severe, and that the recovery would be drawn out. This appeared to put pay to hopes of a V-shaped recovery, prompting investors to dump equities in significant qualities and prompting demand for other risky assets to follow suit.

Evidence that some US states were seeing a rise in virus infection rates both raised concerns about further coronavirus outbreaks, and the possible policy response, and underlined Powell’s message. This wasn’t a quick fix.

It contradicted the message that investors had perhaps erroneously taken from the unbelievably positive US labour market data published on the previous Friday, which showed a large rise in non-farm payrolls rather than the expected massive fall.

Economists have been saying for some time that a V-shaped recovery is highly unlikely, particularly given the lack of an actual vaccine to protect humanity from coronavirus. On-going lockdowns are possible, although maybe only on a regional basis, but social distancing is vital, which rules out strong activity growth in areas such as hospitality, leisure, travel and related industries. So, while the economy may reopen, it will take a long time to get back to pre-virus norms and less economic activity inevitably means higher unemployment, which means less spending and so on. There is no magic switch…

But investors were possibly not only betting on a quick recovery, or at least, not all investors. Behaviour is being strongly influenced by central bank interventions. When a central bank cuts rates to zero (or near enough) retaining cash is less attractive and lending it to other organisations/banks at close to zero equally so. The search for income therefore drives money into non-cash assets, such as equity and commodities. Add abundant liquidity into the mix, due to central banks engaging in huge and rapid asset purchases, and the effect on asset valuations is magnified.

So, does this week’s pull back suggest that investors have seen reason and are valuing equities more appropriately for a protracted economic recovery? Possibly, but it is more likely that the news flow simply made some investors jumpy, while others just saw a chance to take profits from the amazing run since late March. And with central banks such as the Federal Reserve moving to potentially unlimited asset purchases, injecting ever increasing central bank liquidity, further financial asset price inflation seems inevitable as investors move back into the markets, in spite of the economic outlook.

The pull back this week certainty feels like a temporary hiatus rather than the start of a sustained downturn.