‘Natural Symbiosis’ Between Stocks, Fundamentals ‘Rendered Almost Dysfunctional,’ One Bank Says

Over the course of the market’s dramatic rebound from the March panic lows, one of the most difficult questions to answer is this: Is the disconnect between equities and the economy even more absurd than “usual”?

There are two parts to this discussion. The first part entails reiterating that, in the post-financial crisis world, ultra accommodative monetary policy means financial assets can (and will) simply ignore fundamentals, turn a blind eye to economic policy uncertainty, and brush aside geopolitical tumult. See no evil, hear no evil, speak no evil.

Market-based measures of volatility became totally disconnected from news-based measures of geopolitical uncertainty during 2016 and 2017, for example. Even as populism swept across western democracies, threatening to reverse decades of globalization, rates volatility remained moribund and the VIX hit a record low. Note that the chart (below) is monthly, so the highest points on the VIX during, for instance, February 2018’s dramatic spike, don’t appear, but it gets the point across.

Forward guidance was a big part of ensuring that disconnect remained intact. Eventually, market participants simply gave up on contesting central banks’ power and everything became a manifestation of the short vol. trade. “Markets gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting”, Deutsche Bank wrote in early 2018, describing the state of affairs.

The second part of this discussion involves recognizing that there’s a natural mechanism by which emergency measures taken to combat crises create a disconnect between asset prices and the economy. If one acknowledges that markets will be inclined to respond favorably to evidence of policy support, there will be some disparity between the poor economic conditions and deteriorating fundamentals which prompted the policy response, and forward-looking markets.

That latter kind of disconnect isn’t necessarily “bad”. It’s just a reflection of the fact that assets (especially stocks) tend to pull forward future outcomes. The former kind of disconnect — wherein financial assets and market-based measures of volatility remain persistently somnolent no matter what’s going on in the “real” world due to the potent combination of liquidity provision and forward guidance — is arguably less healthy, as it can eventually mean that markets atrophy and cease to function as price discovery mechanisms.

In a note out last week, SocGen’s Solomon Tadesse touches on these issues, and does a nice job summarizing the overarching dilemma as set forth here at the outset. “The spectacular rise in global equity markets despite worsening macroeconomic fundamentals has raised questions regarding the presumed strength of the connection between financial markets and the real economy”, he writes, adding that,

Conventional wisdom holds that stock markets plunge as expectations for the health of the economy and corporate earnings decline. Countercyclical monetary policy initiated at that precise point aims at healing economic fundamentals, and usually leads to an economic recovery in tandem with a stock market rebound. In the wake of the current pandemic, however, unconventional monetary policy in the form of marshaling massive direct asset purchases appears to have desensitized financial markets from underlying economic woes, leading to the Great Disconnect whereby markets surge as economies crumble.

Again, some of this is to be expected due to the dynamics outlined above, but this time around, the disconnect is so glaring that it has many asking what, exactly, equity prices represent. Because it’s certainly not earnings, and it’s not the real economy either.

You can, of course, argue that stocks are looking ahead to brighter days, but this is a really (really) dark tunnel. And given recent developments on the virus front, it’s not entirely clear there’s a light at the end, nor is it clear what the longer-term, structural damage to the economy will be.

The connection between equities’ surge back to records and central bank action is obvious.

It’s true that fiscal policy has played a very important role in bolstering confidence, but the rapid provision of liquidity and global, coordinated easing push, were the controlling factors in bolstering stocks.

SocGen’s Tadesse underscores this. “Unconventional monetary policy has been an overwhelming driver of stock market performance and a key lever in creating [the] disconnect between financial markets and the real economy”, he writes, in the same cited note.

The relationship between the Fed’s balance sheet and the return for US equities was already impossible to ignore and became even more glaring in the wake of the pandemic.

“The trajectories of market performance and the Fed balance sheet appear to have converged into lockstep”, Tadesse goes on to say, noting that returns on the S&P from the end of 2008 almost perfectly match the percentage growth of the Fed’s balance sheet, and the same is true of the March-June period in 2020.

He looks much deeper than that, though. Specifically, he sets out to answer a number of questions, including: “How strong and systematic is this relationship? Does it vary between conventional and unconventional monetary policy tools? And across time? How predictable are asset returns based on Fed actions, and how can they be exploited to enhance investment performance?”

While delving into the specifics of each question is beyond the scope of this post, one critical bit is as follows,

[The] effects are much stronger when we look at how Fed actions correlate with cumulative stock returns over the weeks of t + k. In terms of the direction of impact from policy to market performance, Fed balance sheet growth and changes in the fed funds rate have similar implications — monetary easing stimulates, while monetary tightening depresses markets. The absolute magnitude of correlations of subsequent market returns to changes in the shadow rate is smaller than the correlations with Fed balance sheet changes. The correlations are slightly higher than those for FFR changes because shadow rates also pick up impacts of monetary policy actions other than rates policy.

This doesn’t control for any of the myriad factors that might influence monetary policy and markets together, but the point is simply that there is plenty of evidence to back up the prima facie assertion that central bank asset purchases are driving equity prices higher over time.

Again, the full note contains detailed attempts to address the other questions posed by Tadesse, but the broader point (and this brings us full circle) is that what we are currently witnessing may represent a wider disparity between “reality” and financial asset prices than would normally be the case even considering the post-financial crisis context and the fact that markets will price in countercyclical policy action before the economy reflects it. As Tadesse puts is,

Granted, the countercyclical nature of monetary policy would typically tend to create a wedge between financial markets and the real economy, as monetary easing (conventional or unconventional) introduced at the height of economic downturns tends to prop up asset prices at the point when economic conditions deteriorate. However, the massive scale of this intervention during the current pandemic may have brought the disconnect into a glaring light, with monetary policy annulling the natural response of markets to economic fundamentals and short-circuiting this natural symbiosis to the point of rendering it almost dysfunctional.

And yet, as I’ve mentioned time and again in these pages over the past several years, there comes a point when one needs to separate how things “should” be, from how they are, lest your P/L should end up reflecting that disconnect, which would not necessarily be a good thing.

“Taking a positive, instead of a normative philosophical stance, to this Fed Put, there appears to be a silver lining to active investors in the short to medium term”, Tadesse writes. “Market returns are strongly predictable based on Fed actions”.

Don’t fight the printing press.