Is there a disconnect between share markets and economic reality?

On the back of a global pandemic and the worst economic contraction in US history¹, the S&P 500 and NASDAQ indices kicked off September at record highs, and even the Dow Jones is approaching pre-pandemic levels. This suggests a level of confidence in the US business sector that extends much more broadly than the tech giants who have done relatively well from the pandemic, although they are certainly leading the recovery.

The contrast played out in the media almost on a daily basis between this market confidence and dire predictions for output is striking. For example, a recent National Association of Business Economists survey showed half of economists think that US GDP won’t return to pre-pandemic levels until 2022.²

Is this confidence justified or are investors turning a blind eye to the realities of the situation?

In answering this question, it’s important to remember that media coverage of economic data and market movements usually reflect the reality of two different time periods. Economic data releases are typically retrospective, whilst market movements are based on sentiment about the future performance of those assets.

This is why we often find that market performance leads economic data. Not perfectly, by any stretch of the imagination, but enough that we can say that the state of play reflected in recent market results represent a brighter future than the situation represented by recent GDP numbers.

Markets certainly led the way down into the recession, tumbling well before we could fully comprehend the extent or severity of the pandemic and the measures that governments would take to protect their citizens. To a large degree, the big falls in major indices in February and March actually reflect the reality showing through in recent economic data, and their recent exuberance signifies confidence that a light is emerging at the end of the tunnel.

Investors have been known to get it wrong, but in this case, I think there’s most certainly room for optimism.

From a US perspective, new case numbers have been falling since July³ off the back of the second wave, and deaths declined slightly through August⁴. The case fatality rate – the proportion of those diagnosed who are dying – has also fallen significantly from the first wave. Whether that’s because we’re getting better at treating the disease or more testing for it is irrelevant to this point; what matters is that the second wave looks to have been less fatal than the first back in March and this has enabled the US economy to continue to recover with only a slight pause.

Regardless of when the first vaccine actually arrives, we seem to be getting closer to that day and with so many irons in that particular fire it would seem the market is effectively pricing in the probability that one of them proves to be effective in the short-to-mid term.

Official data and leading indicators out of China support the case that economic activity there has already rebounded strongly, meaning that one of the key engines of global growth for the last few decades is firing again.

Finally, we can’t ignore the probability that share market valuations are being boosted to some degree by the low interest rate environment, which makes less stellar returns from equities markets look good in comparison to the prospects from cash and fixed interest alternatives.

¹https://www.npr.org/sections/coronavirus-live-updates/2020/07/30/896714437/3-months-of-hell-u-s-economys-worst-quarter-ever
²https://www.forbes.com/sites/sergeiklebnikov/2020/08/24/economists-warn-us-gdp-wont-recover-to-pre-pandemic-levels-until-2022/#615a0d475078
³https://coronavirus.jhu.edu/data/new-cases
⁴https://covid.cdc.gov/covid-data-tracker/#trends