En profundidad

Are macro and markets dancing to the same tune?

Last year will be forever remembered as the ‘Great Lockdown’, when Covid-19 sent the world into the deepest recession since the Great Depression. The real economy was brought to a sudden standstill and social distancing became the norm.

But there was a striking disconnect between economic reality and the market, where the slump was relatively brief and risk assets, particularly equities, rebounded even higher than pre-Covid levels.

Several explanations have been given for this decoupling.  The main one being that markets are forward-looking in nature, so asset prices reflect investors’ expectations on future economic growth and corporate earnings. In comparison, most of the economic data tells us what has happened in the past or the current status of the economy.

So, besides keeping economists employed, what is the point of watching the macro when the market takes the lead?

While markets are forward-looking, they are also irrational at times as their mood reflects investors’ sentiment and biases. So watching the macro enables us to better understand whether markets have diverged too far from fundamentals. Conversely, the pricing in the market also provides us an indication of the macro outlook.

Markets have tendency to overreact

The economic data has generally been better at calling recessions than the stock market. The latter tends to have periods when it turns overly pessimistic when confronted with bad news. Chart 1 shows the odds of a recession in the US based on the performance of the S&P 500 and employment data. We use nonfarm payrolls to measure employment. Besides being a key data release closely monitored by investors, it is also one of the economic indicators on ‘recession watch’ by the NBER (National Bureau of Economic Research). The NBER officially dates recessions in the US.1-macro-vs-markets.jpg

Looking at its historical track record, there have been more episodes when US equities have been more bearish on the economy than justified by the macro fundamentals. For instance, the sharp sell-off of the stock market in 2015 to 2016 sparked recession fears in the US.

But investors eventually woke up to the reality that the world’s largest economy was still growing, and jobs were being created. The S&P 500 went on to deliver double-digit returns at the end of 2016.

Reassuringly, both the market and macro are currently dancing to the same tune by signalling that there are no recession risks in the near-term.

How do consensus growth expectations compare with the market?

Compared to a year ago, US consensus growth expectations have experienced a surge in forecast upgrades by economists (chart 2). This is thanks to the significant fiscal support from policymakers and the latest roll-out of the vaccines, which should help with the return to economic normality.

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Chart 2 shows that there is typically a good relationship between consensus GDP forecasts and S&P 500 returns. Clearly, there was a disconnect last year when Covid-19 triggered a fall-out in the stock market but took an even larger toll on growth forecasts. Currently the upgrades in consensus growth expectations appear slightly more optimistic than the market.

What are the business surveys telling us about the market?

One of the most followed macro indicators is the purchasing managers’ index (PMI) which measures the outlook for businesses, so it is considered a leading barometer of economic activity. Chart 3 shows that the recent rally in world equities has been broadly consistent with the improvement in the global manufacturing PMI. The same conclusion can also be found by comparing the performance of global equities (or even US equities) with the US PMI or ISM surveys. Overall, the business surveys appear to agree with the market.

 

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In the credit markets, investment grade and high yield bonds seem to have already priced in the good news on economic activity, as spreads have tightened to historical low levels (chart 4). Similarly, the performance of cyclical versus defensive sectors appear to have discounted the robust recovery (chart 5). Even the domestically-exposed small caps have managed to beat their larger peers with gains in line with the improvement in the macro fundamentals.

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But there has been a divergence between the macro and the performance in some of the equity sectors. The more economically sensitive and value-oriented sectors, such as energy, financials and industrials, have lagged the rally in the overall equity index (chart 5). They are also areas of the market most likely to benefit from the re-opening of the economy and easing of lockdown restrictions.

So, does this mean that these sectors are due a stronger comeback? It depends, as their performance is strongly connected to the interest rate cycle and the path in bond yields. US Treasury yields have started to catch up with economic fundamentals, but they have clearly lagged (chart 6). There have also been periods, after the global financial crisis and sovereign debt crisis, when the macro and bond yields have diverged as quantitative easing put a lid on higher yields. While there could be upward pressure on bond yields from stronger activity, our view is that the  low rate environment can persist for some time.

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Overall, the equity market is generally moving to the macro beat with less harmonious relations within some of the sectors. Finally, the disconnect between the economic data and the bond market is likely to narrow but separation is likely to remain for now.