By Ricardo Evangelista
WITH the global economy contracting at the fastest ever peacetime pace, it is bewildering to see stock markets moving in the opposite direction. So, why are investors endangering their capital at a time of such uncertainty by speculating on the performance of risky financial assets that, ultimately should be directly related to the what happens in the underlying economy?
Let’s take a closer look at the United States. The American economy contracted 4.4 percent during the first quarter of this year and even worse results are expected for the second quarter; the unemployment rate jumped from 4.4 percent in March, to 14.7 percent in late May, with more than 40 million Americans filing new unemployment claims during this period. Meanwhile, the number of COVID-19 related fatalities in the country exceeds 100,000, with political bipartisanship hindering the much-needed coordination between federal and local authorities.
One would think that is such a scenario the country’s stock market wouldn’t be booming. Well, think again!
Since hitting the lows of mid-to-late March, the major stock indices haven’t stopped adding to their value. The Dow Jones and the S&P500 both climbed more than 40 percent with a similar trend also seen in Europe, where the Eurostoxx50 index has also gone up by 30 percent. Financial markets have been propped up by central banks, with a pivotal role played by the American Federal Reserve, through its asset purchase programme that now includes private sector corporate debt. This measure ensured that corporations’ access to credit remained in place, avoiding what otherwise would gave been a torrent of bankruptcies that would have damaged the economy even more.
Despite its importance, the FED’s decisive actions aren’t the only reason why stock markets keep shrugging aside bleak economic prospects. Another factor is the sentiment in the market, which is determined by how investors perceive a given situation. Recent news, pointing at the starting of the tests on a coronavirus vaccine, had a noticeable impact in the financial markets’ risk appetite, which benefited stocks and penalised traditional safe-havens.
Trading based on algorithms and AI is increasingly common, however, human emotions still play a big role in the markets. Humans are inherently bad at evaluating risk; it’s well documented that novelty increases perceived risk; we mostly fear what is new.
Another commonly accepted rule of risk states that numbers are numbing; the greater the number of victims the more desensitised we get. Notwithstanding today’s number of active cases, daily infections and casualties being higher than when lockdowns were initiated in March, most of us now feel safer, happy to engage in the relaxation of social distancing rules (this is of course also dictated by economic necessity).
The same logic is prevailing in the financial markets; despite the state of the economy being considerably worse now, than at the end of March, investors are finding reasons to see a glass half-full, instead of looking for the safety they so required during the early stages of the pandemic.
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