In the middle of a global economic shutdown that has led to soaring unemployment rates around the world, some strategists are arguing that rapidly rebounding equity markets have become “divorced from reality.”
In a research note published late last week, Bank of America chief investment strategist Michael Hartnett said government and corporate bond buying by central banks was essentially creating “fake markets.”
“Why would anyone expect stocks to price rationally?” said Hartnett, noting that central banks have been buying US$2.4 billion in financial assets per hour for the past eight weeks.
As of May 20, the U.S. Federal Reserve’s balance sheet stood at US$7.09 trillion — the highest level ever. In response to the economic shutdown, the Fed has injected trillions of dollars in liquidity into markets through such measures as quantitative easing, with the bank buying corporate bonds and ETFs for the first time in its history. It has continued to scoop up assets in the form of junk bonds and junk-bond ETFs.
Since the beginning of March, the Fed’s balance sheet has increased by nearly 70 per cent.
Central bank intervention of this magnitude was always likely to help stabilize the markets and convince investors to go long. The phrase “Don’t fight the Fed” has become a mantra among some investors on social media.
Given the crisis, the Fed certainly had to act, but the markets have gotten to the point where they’re overly reliant on the central bank, according to Sven Henrich, market strategist and founder of NorthmanTrader.
“There’s a Pavlovian reflex on the side of investors to chase the Fed, and the asset price exacerbation is a side effect,” said Henrich. “They’re fake markets because they’re no longer related to any fundamental analysis whatsoever.”
There’s a Pavlovian reflex on the side of investors to chase the Fed, and the asset price exacerbation is a side effect
Sven Henrich, NorthmanTrader
While markets are forward looking and some have argued they’re trading on the future hopes of investors, Henrich attributes their current levels to the Fed’s interventions.
The S&P 500 is trading at October 2019 levels, Henrich said. At that time, U.S. unemployment sat at three per cent and there were projections of earnings growth for 2020. Now, unemployment sits above 20 per cent and EPS projections call for a 20 per cent decrease, he said.
Tech stocks, for example, have surged past their all-time highs despite having little in the way of fundamentals to back them. Henrich pointed to Amazon.com Inc.’s stock hitting its record high and trading at a P/E ratio north of 116.
“The danger in all this is that you are fuelling and keep fuelling an asset bubble that’s completely dependent on ever more intervention and the Fed (doesn’t have) a single path for how they’ll extract themselves.”
According to Hartnett, central banks are set to decrease their buying in the next couple of weeks to US$608 million in financial assets per hour, which would amount to a 75 per cent reduction.
Crescat Capital portfolio manager Tavi Costa, whose hedge fund is net short, believes markets are overdue for a pullback and that a ramping down of Fed purchases could trigger such a move.
Any economic deterioration, however, would likely be followed by more intervention from the Fed. That might lead markets to stabilize again, he said, but such a cycle can’t go on forever.
“I’m not sure if we’re going to see fundamentals improving just because of money printing,” Costa said. “Money printing can fix the issue in the short term, but it’s not sustainable.”
Scotiabank deputy chief economist Brett House said there’s no cap on what a central bank like the Fed can continue to do in terms of buying. The only thing that may stop the Fed is if the process creates inflation, which is actually going down, he said.
That will allow the Fed to have additional wiggle room going forward. Although he agreed that the markets would not be at their current levels without the intervention of central banks, he calls the notion that they’re propping them up “misguided.”
“They’re providing the bridge financing we need to get us from the beginning of the shutdown to reopening,” said House. “They’re ensuring credit markets continue to function and yields remain at sufficiently low levels for business to finance themselves in what is a completely artificial situation.”