Market Resilience

Market Resilience

The resiliency of the equity market has been evident over the last several weeks as the uncertainties of the election, COVID-19, and the stimulus proposals were absorbed and discounted, yet they were unable to derail market valuations.

As greater clarity of these events emerged, fundamentals were taking center stage.  The reopening of the economy, the earnings recovery, and the monetary fundamentals dominated market behavior.  Real GDP expanded at a 33.1% annualized rate in Q3 following a decline of 31.4% in Q2.  Employment gains exceed expectations.  Initial jobless claims are at 700,000 on a weekly basis and continuing claims have fallen below 7 million.  However, more than 1 million people were added to long-term unemployment (27 weeks or longer) which reached 3.6 million.

The Coronavirus will continue to disrupt business activity in selective areas as limitations are placed upon certain activities in high hospitalization regions.  The responses to the virus will constrain growth, but are unlikely to derail it unless a massive shutdown occurs.  The progress with the vaccines is encouraging and should be the tool to fight COVID-19 in 2021.

Against this backdrop, the monetary authorities are poised to continue and intensify, if necessary, additional accommodation.  They have made it clear that they view COVID-19 a risk to sustaining economic growth, despite the dramatically improved employment picture.  Furthermore, from their perspective, the definition of full employment is changing.  It is going to involve achieving success with unemployment among select groups like minorities, as well as attaining real (inflation-adjusted) wage gains.

Recent inflation rates for the Consumer Price Index (CPI) and Core CPI at 1.2% and 1.6% year/year respectively continue to fall short of their 2% target.  Moreover, the Fed has adopted flexible inflation targeting – averaging 2% for a period of time.  This flexible target implies rates in excess of 2% and maybe 2.5% to 3% before the federal funds rate is raised.  This stance is unlike previous periods when the monetary authorities have often responded in anticipation of achieving their inflation target, given the lagged response to policy.  Going forward they appear willing to wait until there is clear evidence of the sustainability of their goal.  Consequently, a 0-25 basis point federal funds target is unlikely to change anytime soon and may well be at that level through 2022.

In such a setting of near zero interest rates for the next two years, the equity market has little competition from the fixed income market.  Negative real rates (inflation rate minus the federal funds rate) and explosive monetary growth (M2 rose at a 33% annual rate for the six months ending October 19) are constructive for economic growth and stock valuations.  In addition, an earnings yield in excess of 4% verses 0.9% for the 10-year Treasury, and -0.54% for the 10-year German Bond are favorable factors.

The cyclically sensitive sectors that have been punished due to the Gepression (government induced shutdown of the economy) are now recovering and experiencing improving profitability.  Market breadth is expanding, and many more sectors are participating.  Most certainly, volatility is likely to remain for some time as COVID-19 fears surface and resurface.  However, the apparent success of vaccines and the firepower that is being brought to bear to move the economy forward is not likely to be ignored by the equity market.