His mood swings have become more frequent. Depending on the day, the narratives vary from:
- Stocks are up because vaccines are being rolled out
- Stocks are down because of new variants of COVID-19
- Stocks are up because economies are recovering
- Stocks are down because economic recovery is driving government bond yields up
- Stocks are up because lower government bond yields suggest rates won’t rise anytime soon
- Stocks are down because lower government bond yields suggest the economic recovery is in trouble.
To cut through the noise, this is how we would navigate Mr. Market’s mood swings.
For starters, economic and earnings recovery is continuing. Don’t be spooked by every little bump on Recovery Road. Even if there is a slowdown in the rate of expansion in some of the latest data, there does not appear any serious obstacle to overall robust growth for the year.
Indeed, the International Monetary Fund (IMF) has just upgraded its forecast for US economic growth for this year from 6.4% (in its April “World Economic Outlook” report) to 7.0% early in July. IMF also upgraded its GDP growth forecast for China from 8.1% (in its January “World Economic Outlook” report) to 8.4% in April.
Corporate earnings are also surging – 39% in 2001 for the S&P 500, 48% for the MSCI Europe. 21% for MSCI Japan, and 17% for the MSCI China.
Zero rates, extreme monetary expansion, and unbridled fiscal stimulus are very supportive of asset prices. Next: Valuations are inverse to rates. That’s an instant “sugar hit” for asset prices. Meanwhile, Developed Market central banks have been big buyers of government bonds, mortgage-backed securities, corporate credits, and in Japan, even stocks. That drives yields even lower, and by relative valuation, pushes asset prices up across the board.
Meanwhile government spending and “helicopter money” have boosted the economy and corporate earnings. That is another “sugar hit”.
But no, this is not the “forever bull market”. Somewhere during the rally, Mr. Market got so “high” on the sugar hits, he started talking about a “new paradigm”. The driver of that “new paradigm” is “MMT” or “Modern Monetary Theory” – the idea that you might as well merge the central bank with Treasury, with the former printing and the latter spending, with joyous abandon. But our humble take on this is, there is (still) no such thing as free lunch. Somebody eventually pays.
Rates will eventually rise – but not yet. Economic growth is coming back strongly in the Developed Markets and China. Since Developed Market policy makers have been throwing more stimulus at their economies, they are seeing stronger inflationary pressures than China.
Yet, there is still considerable slack in labour markets. So, DM central banks are likely to allow inflation to overshoot their long-term targets to (in the language of the Federal Reserve) “entrench average inflation” around the target rates. For the Federal Reserve, that is likely to start late-2022.
Meanwhile, Mr. Market will get more manic-depressive. However, even before rates rise, the lunch tab has already been presented, albeit in another manifestation. Such extremes of policy stimulus make markets more nervous, exacerbating those moods swings. Aware of the likely eventual reckoning for that “lunch”, those mood swings are becoming shorter and more frequent.
The pandemic continues but vaccines and treatments will likely make COVID-19 less deadly. The pandemic is by no means over. There are more infectious new variants.
But aggregate global data from John Hopkins University is not as gloomy as Mr. Market’s mood swings might suggest. Of course, it has to be recognised clearly that in absolute numbers, more people are dying on a daily basis today than in April last year.
However, while there are more cases today, the mortality rate as a percentage of infected persons has declined sharply. At the peak of the last “wave” – late April/early May this year – the global death rate was around 1.7% of infections. April of last year, the mortality rate was almost 9% of the infected.
Also, the peak of infections late April-early May this year had fewer cases per million of population than at the peak of the previous wave in January of this year. The case rate per million of population is now lower than the bottom of the previous “cycle” in March of this year.
Yes, published research suggests that even for the fully vaccinated, the major vaccines may have lower efficacy against the Delta variant – down to as low as 60%-63% (for Astra Zeneca) against asymptomatic infection. They still have very high efficacy – above 90% - against severe COVID-19 (even for Astra Zeneca). Meanwhile, treatments against infections will become more effective. So, gradually and painfully, as vaccines roll out, the world will adapt to living with COVID-19, and economies will continue reopen.
But in the process, there will be a divide between the “vaxed” and the “vaxed-nots”. There will be divergences between the economic performances of the Developed Markets and Emerging Markets, on faster vaccine roll-out in DM. Generally, Developed Market economies have relatively high rates of vaccinated people, with the UK leading at 57% and the US close behind at 50%, according to Bloomberg data. Emerging Market vaccination rates, according to Bloomberg, are generally much lower, with some notable exceptions both in DM and EM.
There will also be divergences between Emerging Markets ex-China and China, on the same factor of a much faster vaccine roll-out in China. Again, there are notable exceptions among EM countries – e.g. UAE, Israel and Chile – but generally, vaccination rates tend to range from single digits to around 20%. China stands out at around 41%. Also, China has the advantage of arguably some of the most effective social controls in the world against the spread of COVID-19 – controls that allow the economy to function as close to normal as evident anywhere in the world.
Looking past Mr. Market’s mood swings on China – policy easing is a good thing. Mr. Market had been rather agitated in past months about China not easing policy settings when DMs were throwing every policy tool in the shed at their problems.
Yet recently, when the People’s Bank of China cut its Reserve Requirement Ratio, Mr. Market wringed his hands and said “oh no, it’s a sign that economic growth is slowing in China.” We had written about this before, when we described how Chinese policy makers had been “paying it forward” by conserving its policy resources. So, it has plenty of ammunition which it can use from time to time to keep the economy on a steady growth path.
Last week, the PBOC announced a 50-basis point reduction in the cash that banks must hold as reserves. The weighted average RRR for all Chinese financial institutions still stands at 8.9%. This is fine-tuning – not the “drama” that some commentators have made it out to be. For the record, the reserve requirement ratio for US banks is zero.