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What Makes Markets Rally Despite the Pandemic? |
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14th Jul 2020

Week ahead: Focus shifts to key central banks and coronavirus second wave

A deadly pandemic brought the world economy to a standstill, left millions unemployed and halted economic activity. Yet, the markets remain unfazed, with some stock indices reaching all-time highs in this environment of widespread recession.

Since late April 2020, when economies started to gradually re-open, the financial markets gradually surged, despite grim projections for the months ahead. The S&P 500, for example, was 16% off its all-time high on April 25 and 29% off its March low, even though the US had a record 26 million job losses back then. By June 8 the index had managed to erase all its losses of the year and was climbing back to its pre-pandemic levels. It rose 1.2%, the very same day that economists declared that the US is technically in recession since February 2020.

What is causing this huge disengagement between real economic conditions and market movement? Forex and crypto traders need to understand the causes, given that the overall direction of equity prices does not seem to be having much impact on long term economic growth. 
The gradual reopening of economies has fuelled hopes of a quick economic recovery. The equity markets are not driven by good or bad economic conditions, but rather on investor sentiment regarding whether conditions are improving or not. Stocks are rising, because the economic indicators are showing positive signs. 

The US economy added 4.8 million jobs in June, taking the unemployment rate down to 11.1%, from 13.3% in May. While this is much higher than the historical average, the growth momentum continues. Both services and manufacturing PMI for the Eurozone have improved in June, rising to 47.5, from 31.9 in May.

Japan’s core machinery orders increased 1.7% in May, beating expectations of a 5.4% decline. There is growing evidence now that economic growth momentum has picked up, although it will take years to get back to the pre-pandemic global growth levels.
The low interest rate environment, brought about to boost lending and household spending, is expected to stay for a few years. Almost all major central banks, including the US Fed, European Central Bank and Bank of England, have announced record low interest rates (some indicating a push towards negative territory) till 2021.

Investors tend to move towards riskier assets, like equities, in such climates, to increase long-term growth potential. Lower interest rates can give a boost to corporate profits, but other investment assets like US Treasuries and bonds suffer. Investors fleeing emerging markets see US and European stock indices as safe havens, just like they fled towards US Treasury Bonds in the 2008 financial crisis.

The current rally is also a case of massive liquidity-induced market rises. By the end of May 2020, the US Fed’s balance sheet had expanded by $3 trillion and at the same time, market capitalisation of the S&P 500 had jumped by $2.8 trillion. There has been a huge correlation between equity prices and the Fed’s balance sheet in the past months. Almost every other country has injected massive amount of liquidity into their economies in the past six months. As of July 8, stocks are surging, as investors hope for additional fiscal stimulus from the US government.
The value of major stock indices is actually impacted by the performance of a few firms, rather than the overall economic conditions. Indices like the Nasdaq are heavily weighted by technology firms, which have actually weathered and benefitted from the pandemic. Apart from technology, consumer staples and healthcare stocks are also performing well. Stocks like that of Tesla Motors had increased 340% by June. The $1.2 trillion market value of Amazon accounted for 40% of the entire consumer discretionary sector of the S&P 500 by May.

The Bitcoin and forex markets might be replete with trading opportunities due to the current volatility. However, traders need to keep an eye on the risks as well. For instance, the rising cases of Coronavirus infection in the US and the second quarter company earnings reporting season might bring a halt to the rally. So far, investors have refused to consider pessimistic news, but traders must remain alert.