Covid and stock markets: An amicable divorce
Are financial markets too divorced from reality?
This question comes up frequently now, nine months into a year that has been defined by the Covid-19 coronavirus, a pandemic that the Asian Development Bank estimates could cost as much as $8.8 trillion of global economic output.
The question also prompts grumbles from bankers in some parts of Asia, where equity markets are still well below where they started the year. Singapore’s Straits Times Index is down 23.5%, while Hong Kong’s Hang Seng Index is down 14%. Yet governments in both economies have won plaudits for their response to the pandemic.
On the other hand, some of the bigger stock markets are showing gains for the year so far. Take the US. By September 13, the S&P500 and the Nasdaq Composite Index were both up on the year, although the Dow Jones Industrial Average was still trailing.
In China, the Shenzhen index and the tech-centred Star 50 index were up more than 20%, while the Shanghai Composite Index was 5.6% higher. Japan’s Nikkei 225 was also slightly higher than at the start of the year.
The obvious explanation is the role of central banks, which once again are resorting to staggering amounts of quantitative easing, comparable to the financial crisis – and much more rapidly.
The Federal Reserve has cut interest rates and unleashed a huge programme of asset purchases. The Bank of Japan has, rather typically, decided to buy everything in sight. The People’s Bank of China, reluctant to go too far in its own response, has corralled the country’s state-owned banks into helping out.
However, some people feel this explanation only goes so far.
While global central banks have indeed flooded their markets with cheap money, shouldn’t nervous investors be parking this extra cash into the bond markets? Shouldn’t stock markets, which are meant to be the proxies of so much more than just rate expectations, be struggling in a world where almost every large economy is expected to contract this year?
The conclusion seems to be that the coronavirus is not causing a dislocation between asset prices and reality but simply revealing it. But this may be too pessimistic. Perhaps it is time to accept that the cost of money – in theory a much more fundamental input into bond market valuations – is now increasingly important in the stock markets. Most equity investors use relative factors when weighing up an investment decision, for example by looking at a company’s price-to- earnings ratio and comparing that with other listed companies.
It is more sensible for those of us trying to figure out the zig and zag of entire markets to use intrinsic, rather than relative, methods of valuation
This can explain dramatic differences in the valuations of individual companies but it rarely makes sense for whole markets, since many of those comparable companies will be listed on the same exchange. (This argument doesn’t work so well for global champions, which are listed on a wide variety of stock markets and compete with one another across borders, but it is a workable argument for most stocks.)
It is more sensible for those of us trying to figure out the zig and zag of entire markets to use intrinsic, rather than relative, methods of valuation.
These models typically attempt to get the price of an asset by discounting its cash flows against two key factors: the risk of that individual asset and the risk-free rate of return as represented by, for instance, US Treasury yields.
It seems clear that risk at any individual company, and perhaps all companies, has gone up since the beginning of the pandemic. But in a world that had slowly moved away from the zero interest rate territory that lasted so long after the financial crisis, the interest rate part of intrinsic valuation models has plummeted effectively to zero.
The ability of global stock markets to move past the clear and deep risks of the coronavirus might cause derision in some quarters. But this view is usually based on the assumption that the job of markets is to price risk.
In one sense, that’s correct, since everything is risk. But in a more narrow sense, it’s wrong: company or market risk is only one factor in intrinsic valuation, albeit a very important one. The cost of money is another factor – and when the cost of money is zero, or even negative, it is almost certain to have a large impact on valuations.
That doesn’t mean much when it comes to assessing the risk of the pandemic. Stock markets haven’t figured out anything about the coronavirus that the rest of us have still to learn. But in their own, impersonal, objective way, global stock markets are doing their job.
That should be a source of relief, not of despair.