Decoupling of Stock Markets from the Real Economy
Stock markets are no longer married to the real economy. The couple has separated. Not by mutual consent. There is no consent. One party has unilaterally decided to go on a separate way.
Stock markets are supposed to be a mirror reflection of the performance of the companies that make up those markets. They are supposed to reflect the strength of the underlying economy. When they diverge for extended periods, they are said to have decoupled.
Stock markets are trotting upward and onward. The real economy is pacing downwards and backward. GDP is massively contracting whilst stock markets are rallying. Decoupling is a technical name for divorce. Stock markets have divorced the real economy.
The decoupling was well underway before corona virus hit the globe. It is like a married couple slowly drifting away from each other. Kisses turn to hugs, hugs turn to handshakes, handshakes turn to words and words turn into silence. Passion gets replaced by rational thinking and rational thinking becomes intolerance and boom, divorce. The graph below shows the percentage growth of the S&P 500 (in red) versus the percent growth of sales (in blue) versus growth of real GDP (in green).
The decoupling started after the 2008 financial crisis. By 2014 the S&P 500 was growing faster than the economy and by 2019 the difference was irreconcilable. The difference between sales and real GDP is reasonable. Stock markets are ungovernable. They have departed from fundamentals. The valuation levels do not make sense.
If 2019 looked crazy, then the 2020 picture is the mother of all crazy. Corona virus hit the real economy hard so real GDP growth is negative and sales growth is negative as well. Stocks went into negative growth territory for a little less than a month. They bounced at their own bottom and are now growing again. If the trend continues, by the end of 2020, the difference will simply be ridiculous.
The Stock Rallies are a global phenomenon
All the major stock exchanges are having a rally of some sort.
Real Economy Outlook
The real economy is however, expected to decline, for most countries. Year 2020 is a complete write-off with recovery only expected in 2021, earliest and as late as 2022.
If Stock Markets do not mirror the economy, what are they?
- It’s a casino.
- A global Ponzi scheme.
- A haven of sophisticated gamblers.
- A gigantic mesh of bookies, events, and odds.
- An exciting game of chance, where everyone is a winner; there are only chances of winning small and chances of winning big. There are no chances of losing in an uncontrolled rally.
Decoupling to continue….
- Because at some point in time, depending on policy actions, everyone and their grandmother will jump into stocks.
- If there is deflation, savers will jump into stocks. Deflation signals a bad economic outlook (at least to the mind of the modern-day consumer). Even though prices fall, consumers will not necessarily go on a buying spree. They won’t purchase that brand new TV marked 30% off. No! They will save the money for the uncertain future ahead. But interest rates are too low, they are better of putting that little money into stocks than bank saving accounts. Stocks will rise again whilst the real economy shrinks.
- If there is inflation, money balances loose value quickly. People pile their savings into stocks to at least protect whatever they have got. Stock prices will rise again whilst inflation savages the economy.
- If there is neither deflation nor inflation, the stock market’s rally will continue albeit at a slower controlled pace. Absence of either deflation or inflation will be viewed as confirmation that the economy will recover, even when faced with currently negative GDP growth. No one will have a reason to leave the party. A few more dollars will be thrown into the party.
- The only threat to the stock market rally is the central bank policy. If the central bank decides to withdraw stock market support and redirect liquidity to the real economy, the stock market will crush whilst the real economy recovers ,and the couples get to walk together again. This fantasy is highly unlikely.
Zimbabwenizing the Globe
- Is it possible for a country to enjoy stock market rallies and a decaying economy at the same time?
- Is it possible that a country can suffer from inflation and cash shortages at the same time?
- Can liquidity be hoarded and sold at a premium?
- Can the financial sector face mis-intermediation and dis-intermediation at the same time?
A broken Zimbabwe has faced these types of situations several times in this millennium. Here is quote from a an article in the Zimbabwean Independent published 16 years ago.
Zimbabwe has been afflicted by a severe cash crisis, which Finance minister Herbert Murerwa says was attributable to cash hoarding, inflation, parallel market activities, negative real interest rates, high bank charges on cash deposits and speculative behavior.
A few notes can be taken from this statement:
- Cash crisis due to cash hoarding- this would be closer to a liquidity crisis in non-cash developed societies such as the USA. Its not yet at the legendary Zimbabwean level but its a concern being raise in this article from the Financial Times , as well this article from the The Economist . Both are reputable sources.
- Inflation — no other country in the world can match Zimbabwe’s inflation levels (with all due respect to Venezuela and the Wiemar Republic) but there are some fears that the wanton issuance of new currency by central banks globally might lead to inflation. This time there might be deflation before inflation comes with vengeance (per Bloomberg terminology). Prices might go down before they go up. A calm just before a storm. Prices of big-ticket items and non-essential products will at first drive the deflationary momentum whilst prices of scare basic goods will drive the inflationary momentum. As time goes by, inflation becomes more pronounced than deflation as people eschew storing value in monetary form and desire to store value in any real asset. The line between positive demand stimulation and inflation is very thin. It can easily be crossed. Pumping money into an economy that is faced with declining real GDP is generally not a bad idea but the devil is in the details of how this money is pumped into the economy.
- Negative Real Interest rates-people are pushing for negative nominal interest rates across the world. Be careful what you wish for!. Negative nominal rates can easily turn into negative real interest rates, especially when you have inflationary pressures in the horizon. Whilst low interest rates traditionally stimulate the economy, negative real interest rates kill the economy. The line is too delicate.
- Speculative Behavior-from hand sanitizers to Amazon shares, speculative behavior is creeping in fast. It will first hit the stocks, then the commodities, then the basic goods and eventually everything else if the economies do not open early enough.
As an example, deflation has already set in for some products. The chart below shows Month-on-Month Inflation rate for the United States. The 0.8% drop is mainly due to petrol prices but other products have contributed to the decline.
Remember, it starts as deflation and then quickly turns into inflation.
The idea is not to draw parallels between what was happening in Zimbabwe and what is happening in other countries right now. Its not even comparable. The idea is to learn the effect of certain policy actions.
Be of good cheer, your country is not headed towards becoming a Zimbabwe. Don’t bulge in to fear-mongering.
In times of economic distress caused by huge shock such as COVID-19, it is very important that monetary supply growth be targeted towards productive sectors of the economy. Supply side-interventions are key to ensuring supply chains are not broken beyond repair. Demand-side interventions should provide safety nets to the most vulnerable of society in order to avoid massive demand destruction. Money creation should be done gradually , it should be drip-fed into the economy.
The financial sector will seek to decouple from the real economy, hoarding of liquidity will arise among other rent-seeking behaviors. Speculative activity, inflation and negative real interest rates attack the corpus of the economy. The “how” part of policy implementation becomes as critical as the “what” part. It is not just about injecting liquidity into the economy, it’s about how you go about doing that.
The overarching idea should be to avoid decoupling of the financial services in general (the stock markets in particular) from the real economy, because if that happens for an extended period of time, the ability of policy actions to shape the trajectory of the economy becomes very limited. Government and central bank actions become very ineffective in getting the economy out of the rut.
Financial literacy to the world!
Ciao my Fellow Humans!