Don’t be fooled by the economic data

Don’t be Fooled by the Economic Data

By Roland Rousseau

When investing offshore, investors often take their direction from economic trends and data. They believe the equity and bond markets take their lead from the latest inflation and GDP growth data.

But the reality is that the stock market is a very good leading indicator of the economic data and not the other way around. Take the 2008 October equity crash and subsequent recession. The National Bureau of Economic Research (NBER) in the US declared the recession in December 2008. By that time, the market was already down 37% for that year. Effectively the market had pre-empted the recession months in advance.

Unfortunately in 2020, many professional investors have been focusing on the poor economic data that will result as a consequence of the Covid-19 pandemic and cautioned investors to avoid taking risks and to rather move to cash or hold back on investing offshore until economic data improve. Unfortunately, this behavioural bias of relying on economic data which are in effect lagging, prevented many investors from participating in one of the biggest and fastest market recoveries.

An old Wall Street adage is, “markets never wait for the facts”. The deduction is that if you, as an investor, wait for the facts, the market would have already moved on, because facts can only exist in hindsight.

Wayne Gretzky, the legendary ice hockey player once explained that you have to figure out where you think the puck will be two seconds from now. Markets too “think” like this. Eventual GDP or earnings are usually way less important than the market’s current belief in what GDP or earnings might be.

The Market’s Risk Cycle Leads the Economic Cycle
We prefer to focus our attention on where we are in the risk cycle. The market risk cycle is a much more important piece of the investment puzzle that is often ignored in favour of the delayed economic cycle (i.e. estimating GDP trends) or the trailing business cycle (i.e. earnings forecasts).

For example, the yield curve, or more precisely the yield curve spread, is an important risk-appetite indicator and has leading information for equity markets. The yield curve spread is measured as the gap between longer-term interest rates (e.g. 10-year) minus shorter term yields (e.g. 3-year).

An inverted yield curve (negative yield spread) has often been tested as a leading indicator for a recession. We saw towards the end of 2019 an inverted yield curve coupled with a sharply rising equity market which is of even more concern for equity investors. This all ‘unwound’ in February 2020 where Covid-19 was perhaps merely the ‘straw’ or catalyst that broke an already fragile market.

Since November 2018, US 10-year yields have plummeted from around 3% to a recent low of 0.5%. The Covid-19 crisis has only expedited this trend, leading to record equity returns, irrespective of the potential economic damage further down the line.

US Equities have not Overreacted, but ‘Watch’ Bond Yields
The rapid decline in US yields has been a much better estimator of equity returns, despite one of the steepest sell-offs and recoveries ever, over the last few months. US markets are back at all time highs with record low yields. This is not concerning. In fact, our models show that as equities have become more sensitive to falling yields, they have not overreacted but recovered in line with their current sensitivity to lower yields.

This gives us comfort that the recovery is not overblown or that US or global equities will not sell-off relative to bond returns. However, right now, the concern should be for global and US bonds that are staring a potential inflation wave in the face, given all the monetary and fiscal stimulus packages starting to kick in.

Many market experts are rightly concerned about bond yields rising and this means global investors will maintain their equity holdings in favour of bond holdings. At worst, US equities should move sideways in a volatile manner into the US elections season and into early next year but our concerns are around bond returns.

The signal investors need to look out for is rising yields rather than GDP growth, which will remain muted for many months to come. If bond yields rise steadily, this should not negatively affect equity returns. If, however, global bond yields spike, both equities, but in particular bonds, should sell-off more.

Rousseau is a structurer in Rand Merchant Bank’s Global Markets division.

This article appeared in the Financial Mail Investors Monthly, 1 August 2020, p21.