Amidst the gloom and doom, the market's exuberance is confounding

There are several reasons why Mr Market’s enthusiasm has not turned to despondency in the face of this pandemic. While some are more plausible than others, each has a role to play in perking up Mr Market’s spirits.
The Covid-19 pandemic has upended productive activity and sent shockwaves throughout the global economy. Millions have either lost their jobs or are expected to face untold hardships in the coming months. Supply chain disruptions and health care constraints have heaped further pain and misery on distraught societies caught unawares by the virus.

Most major economies are expected to contract sharply in 2020 and contours of the post-Covid world are far from clear. Amidst this gloom and doom however, one phenomenon has confounded many observers. The major financial markets across the world seem to be relatively sanguine about the fallout of the current crisis. For the sake of context, the financial crisis of 2008 had seen the S&P 500 fall by more than 50 per cent from its peak. The Sensex had experienced a similar decline. Given the fact the current crisis is widely acknowledged as being more severe than what the world confronted in 2008, Mr Market, to borrow a phrase from Ben Graham, seems to be in remarkably high spirits.

The S&P 500 is flat for the last twelve months and has declined by only 13 per cent from its peak. The Sensex is down by only 20 per cent from its peak and is still above its level in April 2017. There are several reasons why Mr Market’s enthusiasm has not turned to despondency in the face of this pandemic. While some are more plausible than others, each has a role to play in perking up Mr Market’s spirits.

One reason that has been put forth is that compared to previous crises that were caused by impairment of assets, the current pandemic is a crisis of liquidity. Businesses are expected to lose revenue for a few months that will be recovered once the lockdown and stay-at-home orders are lifted completely. Thus, the productive machinery of the economy is intact, albeit in deep freeze. This means that the pandemic will impair the value of only those businesses that are unable to access liquidity to tide over the period of deep freeze. This explanation, however, seems to be hobbled by strong assumptions about the resilience of demand and our ability to control the pandemic in a timely manner.

Another reason touted for Mr Market’s sangfroid is the discount rate effect. With US risk-free rates close to zero, it is argued that the rate at which future cash flows of the firm are discounted is very low, thereby supporting net present values of the firms and their stock prices.

A major fallacy with this argument is that for this to be true, the fall in risk-free rates will have to offset both the increased risk premiums and also the cash flow shocks from the pandemic. It seems unlikely that a couple of hundred basis points reduction in risk-free rates would be able to mitigate the impact of cash flow erosion and heightened risk premium.

The main reason is that Mr Market has a new friend. This new friend— or should we say friends — are essentially the largest hedge funds in the world with unlimited capital. They have made a public commitment to Mr Market — to “do whatever it takes” (Mario Draghi), to “not hesitate to use any instrument, conventional and unconventional” (Shaktikanta Das) and to “not run out of ammunition” (Jerome Powell).

Moreover, some sensible friends of Mr Market such as “not here to close spreads”(Lagarde) have had to backtrack post- haste to a “no limits” commitment under immense political pressure. Normally, the generosity of these friends — read central banks — would have been constrained by the looming spectre of inflation but the ghost of Weimar Republic and Nixon’s America seems to have been long exorcised.

Despite the massive stimulus and unconditional liquidity backstop by the Fed, the five-year, five-year swaps ( a measure of inflation expectations five years from now) are at a mere 1.32 per cent for the US. Another measure of inflation expectations, the 10-year breakeven inflation rate is at only 1 per cent. Both these measures are at levels much lower than what they were at before the pandemic and the consequent Fed action.

Moreover, even if the possibility of hyperinflation rears its ugly head, its impact on asset prices especially stocks is far from clear. From the experience of the 2008 financial crisis, many believe that an accommodative monetary policy no longer fuels real inflation but leads to asset price inflation, which supports equity markets. There exists some evidence to support this view in Constantino Bresciani-Turroni’s seminal book on hyperinflation in the Weimar Republic.

However, the most important factor behind the stock market’s resilience is that no one wants to trade against Mr Market’s friends, the central banks. No matter how strong the rationale for shorting and selling the market may be, investors now realise that with central banks lubricating Mr Market’s exuberance, the famous words of John Maynard Keynes ring truer than ever — Mr Market can remain irrational longer than you can remain solvent.



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