Have Equity Markets Decoupled from the Real Economy?

Have Equity Markets Decoupled from the Real Economy?

Stock exchanges around the world are registering all-time highs in the midst of a pandemic. Equity markets appear to have decoupled from the real economy. UBS Chief Economist Daniel Kalt explains why that impression is misleading, and what’s driving investors to the stock exchanges.

We’re still a long way from having vanquished the pandemic and overcome the resulting crisis, but stock exchanges nevertheless have recently been reporting record-high share prices. Have equity markets decoupled from the real economy?

I don’t think so. That impression stems from an enormous discrepancy between the small universe of publicly traded companies and the great remainder of the economy. The adverse effects of the pandemic have manifested themselves mainly in the “capillaries” of the economy, impacting SMEs, small and midsize enterprises like restaurants, culture establishments, etc.

Publicly traded companies in comparison, which generally are larger-sized companies, were much better prepared to cope with the pandemic and were accordingly less affected by its impacts. Most of those companies are in good shape.

And this is being reflected in stock prices?

Some of the large publicly traded companies in particular have profited directly from the pandemic. Remote work from home, for example, lit a rocket under technology stock prices. There’s faith in a better future on top of that. One-year-forward profit expectations for publicly traded companies around the world are 30% to 40% higher than actual pre-pandemic earnings were.

The speed at which stock prices recover after a crash depends very much on how severe the disequilibrium in the economy was beforehand.

This owes also to current fiscal policies and ultralow interest rates, both of which benefit companies that traditionally trade as growth stocks – technology companies have been at an advantage here as well lately. Value stocks such as banks, in contrast, have been struggling in this climate.

What does the discrepancy that you described mean for a country like Switzerland, whose national economy is dominated by SMEs?

First of all, every national economy the world over is dominated by SMEs. There are hairdressers, bakers, and carpenters everywhere. The image of Switzerland being a country distinctly jam-packed with SMEs is a cliché, in my opinion. On the contrary, hardly any other country of this size is home to as many hyperglobalized corporations as Switzerland boasts: Nestlé, Novartis, Roche, ABB, and so on. Think, for example, of Austria, which plays in an entirely different league.

This has also helped us to get through the crisis comparatively well from a macroeconomic point of view. Gross domestic product in Switzerland contracted by only 2.5% in 2020 while it plummeted by 7% in the eurozone. The UK registered a nosedive of almost 10%, admittedly also as a result, though, of Brexit.

Gross domestic product figures weren’t all that plunged in 2020 – so did stock prices in spring of last year. Were you surprised by how quickly they subsequently recovered?

The speed at which stock prices recover after a crash depends very much on how severe the disequilibrium in the economy was beforehand. The 2008 financial crisis is a perfect example of an event that was preceded by a period of ongoing aberrational developments such as real estate bubbles in numerous countries and the securitization of subprime mortgages. This means that in the aftermath, those aberrations first had to be corrected. It took years to accomplish that.

The crisis in connection with the pandemic is an entirely different animal. It burst upon a world economy that was in relatively healthy shape without any large excesses in the real estate market, for instance.

I cannot discern a decoupling of equity markets from the real economy.

The halt in consumer spending and the attendant recession came from an unexpected quarter: It was caused by government-ordered lockdowns. Perhaps it was knowledge of this fact that prompted some investors to recognize the low stock prices as a buying opportunity, thus helping to kick-start the turnaround. A way out of the crisis then soon became apparent with the first news reports of successes with vaccines. A recovery on the equity markets came accordingly quickly.

Is it the prevailing ultralow interest rates that are also driving investors into equity markets in the absence of good alternative sources of return?

That can’t be denied entirely. Market interest rates on short-term bonds denominated in Swiss francs have been below zero since 2015. And it appears that these negative interest rates, which were once envisaged by the Swiss National Bank as a temporary measure aimed at weakening the franc against the euro, will be with us for a while longer.

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Perhaps in the end we will have spent an entire decade in this interest-rate environment. That wouldn’t surprise me, especially seeing as how interest rates on long-term loans have also come under enormous pressure in the meantime, due in large part to massive bond buying around the world by central banks with the help of freshly printed money, though lately that of course has been intended to soften the pandemic’s shock on the economy and to stimulate consumer spending.

Central banks as a reliable knight in shining armor – is it perhaps also this image that has stimulated the equity markets?

The term for this is “moral hazard,” the belief in not having to bear the full risk of one’s actions – of one’s investments in this instance. The danger of moral hazard exists. During the equity market crash of 1987 and at least ever since the 2008 financial crisis, central banks have acquired a habit of intervening to brighten consumer and market sentiment.

Interest-rate cuts were long the means of choice for doing this. In the meantime, though, central banks have resorted to buying assets – bonds as I mentioned earlier, but also currencies and stocks. This is a new dimension of monetary policy that equity markets apparently have grown accustomed to as a kind of backstop. 

A backstop that evidently works. Stock prices in some segments of the market are already 20% or more above their 2019 levels. So, one can now also conversely ask if this rally will go on this way forever.

Well, if we look at stock prices over the long run, meaning over several decades, we observe that they in fact do rise continuously and that the infamous crashes were only interim dips. Because stock prices, after all, really do depict a real economic value, that of the corresponding stake in a given company. And that’s a reason why I cannot discern a decoupling of equity markets from the real economy, to come back to your initial question.

I’m more concerned in this regard about bonds, which reflect the flip side of central banks’ expansion of the money supply. Their price levels no longer have much to do with reality. Market interest rates have fallen into an abyss.

Ultralow interest rates are exacerbating disequilibriums also in the real estate market. They have driven up property prices, particularly in Switzerland. If interest rates start to rise again one day, this overvaluation is likely to undergo a correction and there is reason to fear a price collapse. If there has been a decoupling anywhere to speak of, then it’s rather in the bond and real estate spaces.