May 7, 2020

Disconnect? What Disconnect?

Disconnect? What Disconnect?
Disconnect? What Disconnect?

Over the past few weeks, the financial news media has been marveling at what it calls the “disconnect” between stock prices and the economy. Economic and health statistics are likely to go from bad – 30 million unemployed in the past month, a 4.8% drop in first-quarter GDP, an 8.7% drop in retail sales in April, more reported coronavirus cases and deaths – to worse – a nearly 40% drop in GDP and around 15% unemployment in the second quarter, according to the Congressional Budget Office’s latest projections. Yet the stock market has blissfully regained about half of the 34% drop it sustained between mid-February and mid-March.

But is there really a disconnect? Does the economy – now largely controlled by the Federal Reserve and the U.S. Treasury Department – still have any correlation to what happens in the stock market anymore, and vice versa? Well, the answer is yes, but not in the way it used to. What’s happening is that as the economy goes deeper into the red, the more it prompts the government to pump in more money and for the Fed to intervene more in the financial markets. That is unquestionably good for stocks.

We have been in an environment since the 2008 financial crisis where the Fed has played an unprecedented activist role in the bond market and, indirectly, the stock market. That role has grown further under Chair Jerome Powell, who seems to believe it’s the Fed’s job to rescue equity investors any time stock prices correct, never mind what’s going on in the economy. Now that we’re in the middle of an economic downturn that makes 2008 look like a garden-variety recession, the Fed has put its monetary policy and quantitative-easing engines into overdrive, which may or may not stimulate the economy but have surely at least put a floor under stock prices, if not actually boosted their value.

As I’ve discussed in my past few columns, two of the prized economic ambitions of the political left – economic socialism and Modern Monetary Theory – have been fully embraced by the Trump Administration and the Fed to protect the American economy. That should make liberals happy – although as you’ve probably noticed, very little makes them happy, even when they get everything they demand. That’s probably because it usually backfires on them, like now. It must gall them that when put into action, these ideals have actually benefitted the people they despise, namely capitalists and investors. Not only have stock prices rebounded – although they’re still down about 15% from the mid-February record peak – but the income and wealth gaps between the haves and have-nots have widened even more.

I’m assuming that this is not what the Fed intended, but it is the practical reality.

This reminds me a little of how the property insurance industry works. Have you ever noticed that after some “act of God”– a hurricane or an earthquake, for example – the prices of insurance company stocks usually rise, rather than falling as you might expect them to do? That’s because disasters like that just give the insurance companies a reason to raise premiums, increasing their future revenue and profits. After all, they only have to pay claims once, but the higher premiums last indefinitely. It’s good for business, not bad.

That seems to be what’s happening in the financial markets currently. As the economic figures get worse and worse, the Fed and the U.S. Treasury pump more and more money into the economy, which helps stocks. But there’s one big difference between this and my insurance analogy. While insurance companies protect themselves by reinsuring their risks with other insurance companies, theoretically, at least, all of these companies could go bust if the catastrophe was big enough. But that could never happen with the U.S. government and the Fed since all they have to do is print more money when they run out, which is what they’ve been doing.

The Treasury recently announced that it plans to borrow $3 trillion this quarter – more than five times the amount it borrowed per quarter during the 2008 crisis – to cushion businesses, consumers, and state and local governments from the coronavirus. At the same time, the Fed’s balance sheet – which now includes corporate bonds, not just Treasury and government-guaranteed mortgage-backed securities –totals a record $6.5 trillion, up nearly $3 trillion, or 85%, just since last September. And it’s going to get still larger, as it is promises to buy an “unlimited” amount of assets going forward, including a large share of whatever the Treasury has to sell.

How long this state of affairs will last is hard to guess, because it’s never been done before, not even during the Great Depression and World War 2. But right now, it’s redounded to the benefit of investors, and it makes perfect sense, whether we like it or not.

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George Yacik
INO.com Contributor – Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.