Disentangling Market Performance from the Economy

We enter June still hearing continued tragic news of the human impact of Covid-19. The bad economic news is also unrelenting, with the longest economic expansion in US history cut abruptly with what is sure to be a deep, global recession.

In these circumstances, we may wonder why global stock market sentiment doesn’t seem to be as gloomy. This relative resilience highlights a discrepancy – there often appears to be little correlation between what goes on in the wider economy and how markets perform.

Despite widespread economic pain, markets seem relatively resilient

By all accounts, the economy has tanked. The amount of people claiming unemployment benefit in the UK soared by 856,500 to 2.1 million in April (Source: ONS). UK GDP shrank 2% in the first three months of 2020 and by 5.8% in March alone. A “significant recession” is likely on the way according to the Chancellor Rishi Sunak.

Across the pond the economic figures are equally grim, with around 33 million losing their jobs in just seven weeks. Yet the S&P 500 index of leading stocks shook off the shackles of reality and delivered its best April return in 82 years. These returns have consolidated in May, so the index is now down 6.6% so far this year. The US stock market had lost a third of its value at one point in March, but compared to a year ago it is now 8% higher (all as at 26/05/2020).

Markets outside the US have not displayed the same vigour. The UK’s FTSE All-share Index lost nearly 35%, but it has recovered by nearly 25% from its lows in March. Meanwhile, the MSCI All Countries World Index ex-US also slumped, then recovered somewhat, and is now around 2% down over a year (as at 26/05/2020).

Why have markets not been affected on the same devastating level as the world economy?

Looking closer reveals a more nuanced picture

How the market behaves is ultimately a reflection of investors’ views on the aggregated ability of different companies to earn money. From that starting point we can clearly see a lot of differentiation within the market, especially within the US.

The US market is the world’s biggest and most developed, and features a significant allocation to heavyweight consumer technology stocks such as Amazon, Microsoft, Apple, Alphabet (the parent company of Google), Facebook and to a lesser extent Netflix – together representing more than 20% of the S&P 500 index of the largest companies. In many ways, 2020 has so far accelerated some of the digitisation themes that were behind their strengths, so their stock prices have done very well in contrast to other sectors.

The combination of large weights and strong outperformance has added an aggregate of 3.1% of total market performance to the S&P 500 so far this year. If the big tech impact was excluded – as you can see from the chart below – the index would have fallen by 12.5% instead of 6.6%. We can extend this analysis further by showing how the S&P 500 would perform if it were equal weighted, and this deepens the loss to 13.3%, broadly in line with the shortfall across world stock markets.

Other reasons why equities appear resilient

Stock markets are typically forward looking and look for signs that company earnings will improve or at other initiatives that will foster a favourable environment for equities. Swift central bank action worldwide has helped to allay the fears of the market to some extent – borrowing conditions have been made easier and liquidity for many institutions is plentiful.

Further, this week has seen increasing signals that a range of Asian and European countries are progressing to unlock their economies. For the first time, this improving outlook has encouraged investors to look through the present situation to times when some of the most hard-hit sectors can perform again. As a result, it is only now that some market signs of macroeconomic confidence are starting to return, with the same technology stocks trailing the broader market very recently.

The proportion of UK shares held by UK-resident individuals was 13.5% at the end of 2018 (Source: ONS). Therefore, the majority of stocks are not held by private investors, but by institutions such as pension funds, insurance and investment companies. By nature, these organisations take a long-term view and are arguably less inclined to sell their holdings when markets are volatile or uncertain.

But like private investors they also seek the best risk-adjusted returns for their portfolios. The returns from cash and short-term bonds are not very rewarding now, especially after recent actions of the Bank of England, implying again that the volatility inherent in equities might be worth tolerating for better returns.

What this means for investors

While the current environment is undoubtedly more unusual and more troubling than most, we always advise investors to take the long-term view when aiming to achieve their goals. The average investor may receive less than half the returns of the broader market over time when they try and second guess the market, by missing out on the biggest days for returns.

While there may appear to be a disconnect between the behaviour of the economy and markets now, look beyond the headlines and we can see the wider stock market has suffered more when we extract the impact of the big tech companies whose prospects have hardly been dented. Indices which track smaller companies are even more depressed.

The only certainty is that uncertainty will be with us for quite some time. After the recent rebounds in markets, investors need to see some progress on both the health and economic fronts to see continued immediate gains. In the meantime, we encourage investors to be patient, and where they have the means, to stay invested.

Please remember that when investing your capital is at risk.