For the past several weeks, we have been arguing that the performance of risk assets across the world are in total disconnect with economic and corporate fundamentals.
The enormous addition of money supply through fiscal and monetary authorities has been the key driver for stock markets and in the US has seen the S&P 500 recover all its losses for the year and the Nasdaq Composite reaching a new record high. After all, the Federal Reserve has doubled its balance sheet to $7.2 trillion from $3.7 trillion and the administration may still issue new fiscal measures after their initial $3 trillion package.
The scale of those policies in fighting economic depression has translated into a remarkable recovery in financial assets, as the Fed committed to supporting not only blue-chip corporates but also those below investment grade. Hence the risk of insolvency has dropped significantly and investors do not seem worried about the near-term future. Surprisingly, that is also the case with bankrupt companies. Retail stock traders have been piling into stocks like Hertz and JC Penney despite these firms going through bankruptcy proceedings. I don’t think we have ever seen market behaviour like this in recent history.
The Fed is now committed to keeping interest rates near zero until at least the end of 2022 and using all its tools to support the economy. This could translate into further speculative bets and push the rally in equities and corporate debt higher. However, without real economic recovery the market will have to deal with a more significant challenge, which is debt insolvency. That’s why the disconnect between asset performance and economic fundamentals cannot run forever and investors will need to become more rational with their investment approach.
News of a second wave of coronavirus cases has begun to emerge in the US after the reopening of numerous states. While it might take several weeks to know if this is a broader problem, infection counts will again become a key barometer of risk that cannot be ignored. Another steep rise in virus cases will end up delaying the economic recovery further and lead to a rethinking of how to be positioned for a more depressed outlook.
Overall, I think the rally in equities has become overstretched and I wouldn’t be surprised to see a return of volatility with the market correcting to the downside.
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