The line continues to blur between the momentum of financial markets and macroeconomic indicators. Despite some positive economic measures released this past week, including rebounding retail figures and a tapering off of initial unemployment claims, uncertainty dominates as firms and households adjust spending and savings habits. Ultra low mortgage rates fail to induce buyers into the existing housing market, the US trade deficit widens further as global demand for US exports diminishes faster than domestic demand for imports, and a plethora of emergency federal welfare programs for impacted workers soon comes to a close. Meanwhile, financial markets represented by major indices like the S&P 500 and the NASDAQ continue to rally as institutional and retail investors alike participate in the rebound. What could be driving the divide?
One possible explanation takes into account investors’ search for yield in a global economy dominated by historically low (and often negative) interest rates. Yields on domestic ten-year Treasury Inflation-Protected Securities (TIPS) entered negative territory since the precipice of the pandemic in February and have yet to break above zero. Yields on government securities in Japan, Switzerland, and Germany have been negative since before the pandemic began in 2019. Credit spreads on high yield credit securities (those with investment ratings of BBB or lower) have, since March blown out by hundreds of basis points, signifying the dramatic increase in bankruptcy risk associated with more credit-unworthy institutions (see Hertz or Chesapeake Energy). These not unimportant credit market trends have worked to make equities as an asset class all the more attractive on a risk-return basis.
Equity valuations recent clawback of pandemic-induced losses also may be the result of the Fed’s actions to bolster the money supply - ensuring the day-to-day liquidity of corporate giants like United Airlines and Goldman Sachs as well as their long-term solvency. Coupled with historically low interest rates now (and in the foreseeable future), large corporations understand that as long as cheap loans are easily accessible, they too will continue to keep their lights on and sales going, even if that means employee mask mandates or bolstering cash positions on their balance sheet.
The stock market and its investors need not be irrational to explain the past few month’s rally. It may be as simple as Finance 101. Firms are valued based on their future cash flows, discounted at some rate above the risk-free interest rate to today’s present value. Investors understand the rough patch corporate America finds itself in now, but they are confident that this pandemic, with all of its ill effects, will not last forever. Sooner or later when firms begin to see increased profits again, these cash flows will be discounted at a historically low rate, pushing up their current valuations.
Regardless of the true reason(s), markets rely fundamentally on the confidence of their investors. As long as Americans can envision an eventual “return to normalcy”, corporate finance edicts need not be the end-all be-all.