What caused the disconnect between Wall Street and Main Street?

The global economy entered a recession in the first half of 2020. OECD issued a global GDP baseline forecast of -6% in 2020, and GDP of -7.6% in a downside COVID-19 scenario. Geopolitical conflict and civil unrest continue to flare up in  China/Hong Kong, the US and many parts of the world.  A typical investor would expect the stock market to remain depressed for the rest of 2020. However, from March to early June, S&P500 experienced the sharpest rally in its history up ~40% from its March bottom.

Why is there such a disconnect between Wall Street and Main Street?

What positive information did cautious investors miss amid the recent market rebound?

Here are our top five of the key drivers behind the recent US stock market rally.

1. Central banks counter-cyclical monetary actions

You may have heard the old investing mantra “Don’t fight the Fed”. It means that investors can often do well to invest in a way that aligns with current monetary policies of the Federal Reserve Board, rather than against them.

When global central bankers want to save the economy and the financial markets, they will actively purchase their own outstanding bonds to inject liquidity to the market and lower interest rates so the corporates and individuals can borrow funds cheaply, which often translates into higher income as they invest the borrowed money (for high productivity or better process) or refinance existing higher-cost debt. For investors, sticking with stocks when the Fed is lowering or keeping rates low has been a sound investing strategy.

In the past three months, US Fed has launched an unprecedented number of asset buying programs to buy not just US treasuries, but also individual corporate bonds and bond index funds to keep companies afloat and their idle employees paid. Overall, US Fed pledged to inject $4 trillion into the global economy to offset the blow of the pandemic-induced recession. The Fed held interest rates steady (at 0%), indicated they would remain there for the next 2.5 years, and pledged to continue expanding its balance sheet at the current pace.

These new funds from the central banks allow companies to continue pay salaries, maintain their staff and avoid new share issuance. In turn, employees have money to pay rent and buy daily necessities and more. Forced to stay at home with limited entertainment options, some even deploy their paychecks to buy stocks which contribute to the recent market rally.

2. Government counter-cyclical fiscal policies

When the private sector is unwilling or unable to spend, the public sector (governments) often will replace that demand with stimulus spending. Since March, many governments around the world have launched new fiscal spending programs such as cash handouts, increased unemployment benefits, physical and digital infrastructure stimulus programs and increase R&D research funding. For example, when a furloughed restaurant employee uses his/her stimulus check to buy a can of Coke or an new iPhone, he/she indirectly contributes to S&P500’s rebound.

3. Many winners in the lockdown economy

While many businesses in the restaurant, retail stores, real estate, travel and energy sectors have suffered immensely during the Great Lockdown, there are also many companies and industries that are thriving simultaneously. Work-from-home equipment providers, software companies, e-commerce companies, telemedicine companies, cleaning-supply manufacturers and food-delivery businesses were among those winners.

The Nasdaq stock index outperformed S&P500 and other country indices in the last 3 months partly because it has a richer mix of lockdown winners and lighter mix of lockdown losers compared to other indices. Therefore, investors should not simply compare different country stock market valuation (P/E) and performance without considering the drastic differences in sector and company mix across country markets and indices.

4. Escalating geopolitical conflicts drive up spending in certain sectors

History suggests that during times of escalating geopolitical conflict, government ramps up spending in defense, technology, logistics and other sectors deemed important to national security. The US market happens to have a large number of these companies that are publicly listed.

During the World War II, 17 million new civilian jobs were created in the US, industrial productivity increased by 96%, and corporate profits after taxes doubled. Companies like Ford, Alcoa, Boeing and many others benefited tremendously as large civilian suppliers to the allied governments. World War II provided the ideological breakthrough and new market opportunities that allowed the US economy to climb out of the Great Depression.

Geopolitical conflicts also created entire new technologies, industries, and associated human skills. NASA was created in the 1960s when US was racing against its Cold war rival USSR in the Space Race. After 10 years of R&D efforts and spending, US achieved the goal of putting a man on the moon with the Apollo 11 mission in 1969. The US semiconductor industry was a direct beneficiary of this space race as NASA was a major customer of Fairchild, Texas Instruments and Intel in their very early days making transistors to put on board Apollo rockets. Without the Cold war and Space Race, Silicon Valley would not have grown as rapidly in the 1960s and 1970s.

The Internet that we use daily today was first developed in the late 1960s as ARPANET (Advanced Research Projects Agency Network) and was funded by the U.S. Department of Defense. Without that initial moonshot defense research project, we might not have Internet to use today.

History is repeating itself again in 2020.

With the Covid-19 pandemic, Sino-US political conflict and a global technological race, we are now seeing massive research spending on genetic editing, virus drug research, AI, robotics, quantum computing, digital security, and space sectors by both governments and the private sector.  

Even politicians understand that future battles will likely be fought digitally instead of using fighter jets, tanks and troops. In fact, digital battles are being fought daily in form of computer virus attack, phishing email, data theft, data intelligence gathering and surveillance by satellites. It would not be surprising to hear that in the future countries can win a war without shooting a single bullet.

Today, our moonshot R&D efforts are benefiting the US economy in form of stable R&D spending, and employment. In the many decades to come, we believe these new technologies will benefit our civilian lives in many more unimaginable ways.

5. Escalating geopolitical conflicts / economic downturn trigger capital flight towards safe haven assets and markets

When the global economy goes through a downturn, investors flock towards safe haven assets which tend to be in developed markets like US, Europe or Japan. Developed markets have deeper liquidity of safe bond assets and their stock markets are driven by consumers and technology sectors that tend to have more stable demand. On the other hand, most emerging markets have volatile currency, very small bond market and their stocks are heavily dependent on global trade or natural resources sectors that are economically sensitive. 

The US takes advantage of this flight to safety mentality of global investors by selling them US treasury bonds at almost zero interest rate. The government in turn deploys these low-cost capital on domestic fiscal stimulus programs to boost the US economy and its stock market.

The Bottom Line

Despite all the recent negative headline news around Covid-19, geopolitical conflict and civil unrest, there are actually many silver linings behind the dark clouds. As one attempts to predict the stock market in the short term (very hard!), one has to think about the potential secondary impact on any negative events. As always, the devil is in the details.