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A Tale of Two Streets

Guest Opinion

As the coronavirus pandemic continues to wreak havoc, only a handful of countries managed to get out of it unscathed. With no prior experience of the current imbroglio, various governments in the world resorted to the measures of physical distancing and subsequent lockdowns to hinder the relocation of this highly contagious SARS-CoV-2, implications of which led economies to near catastrophe in the short run. Growth rates in nearly all major economies plummeted to a historical low with a corresponding massive surge in the unemployment rates. In the initial months of ambiguities, few noted economists, as well as leaders of the world, vouched for V-shaped recovery of the economy, but as soon as the growth data started pouring in for the first quarter, we witnessed unprecedented contractions, and with that optimism for V shape recovery also diminished.

There are doom and gloom all around, but not in stock markets!

Global stock markets tanked in March. The crash was the fastest fall in the global stock markets in financial history and the most devastating since the Wall Street crash of 1929. However, markets were able to get back to their pre-pandemic pace after struggling for a few months depicting a sweet turnaround.

In a 1966 Newsweek article, noted economist Paul Samuelson famously quipped that the stock market had predicted nine out of five recessions. This remark by Samuelson quite subtly subverts the power of the stock market to influence economic activity. Ever since the stock market crash of 1929 and the onset of the Great Depression, people often intertwine stock markets with economic health. Historically some recessions have been preceded by the stock market crashes including the Black Thursday of 1929 which later culminated in the Great Depression of 1929, 2001 recession, and 2008 recession. However, the Black Monday crash of 1987 was not succeeded by any major recession. Similarly, if we were to analyze US bear markets in the post-war era, we would find that 13 bear markets have led to recession only about 7 times within 12 months(53 percent!).

If we talk about the current situation, stock markets have already started rallying steadily towards their pre-pandemic level. In the United States, the Dow Jones Industrial Average rose 11.4%(the biggest daily gain since 1933) in March-end, depicting one of the shortest bear markets in American history. The S&P 500, London’s FTSE 100, Germany’s DAX, France’s CAC, Japan’s NIKKEI, and South Korea’s KOSPI, all registered significant growth. Between the start of April and August global markets have risen by 37 percent.* This is coming when economists have predicted negative growth for economies around the world in the current fiscal year.

With major economic activities at a halt, with unemployment rates reaching new heights, with few businesses completely shut down, and with many operating at a limited capacity, what explains this paradoxical upsurge in the stock markets? Why does, ‘Wall Street’ seem more lucrative than ‘Main Street’? Why is one soaring and the other is burning? This discrepancy between the both has been a source of much discussion and debate in the last few months and has also been highlighted by the cover page of The Economist on May 9, 2020, “A dangerous gap: The markets vs the real economy” as well. Below we’ll look at some of these factors which would help us in understanding and highlighting the recent dissonance between financial markets, and the real economy.

It is generally considered as a rule of thumb in the stock markets that, in the short run, expectations, collective sentiments, proclivities, and emotions(wisdom, some call it!) drive markets, on the other hand, the real economy tells us about the current situation in the context of events that have already occurred or are taking place at the moment. As the uncertainty hovering around the pandemic has taken a backseat and optimism regarding a viable vaccine coming by the year-end, has influenced people’s expectations and ‘animal spirits' are driving them back to the market. However, to bring expectations to fruition, investors expect a conducive environment to feel optimistic about their investments.

In the current situation, policy actions taken by major Central Banks to deal with pandemic/lockdown induced slump, have played a pivotal role in providing such a conducive environment. Short term interest rates in various countries have gone down to near zero as a part of various conventional and unconventional monetary policies undertaken by the central banks to combat recessionary pressures. Low-interest rates affect Investments positively as it decreases the cost of borrowing which in turn stimulates output. Apart from being positively related to the investment, low-interest rates increase the price of bonds, CDs, etc. and lower their yields. As of now, government bonds are barely positive in the United States. They are negative* in Japan and much of Europe. With a meager expectation of a profitable return from these investments and a potential risk(minimal) of inflation, losses would be more painful. As argued by Keynes, “that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.” So many investors who are looking for a yield on their investments have turned to stock markets to generate a profitable return. As the cost of borrowing is more or less close to zero, a large part of the borrowed sum is being reinvested into the stock markets.

Apart from policy measures, if we take into account how these stock market indices are calculated we will find out that few tech giants hold massive influence in driving the entire stock index up or down. Let us take the example of the US S&P 500 index- composed of 500 of the largest companies in the United States.

S&P 500 is not a simple average of the stock prices for every company in the index, it is calculated by weighting each company according to its market capitalization. It means that larger companies will have a much bigger impact on the overall value of the index. The five largest companies- Alphabet, Amazon, Apple, Facebook, and Microsoft account for roughly 23%* of the S&P 500 index value. Similarly, top companies have experienced significant growth in their businesses largely unaffected by the pandemic (ignoring few initial hiccups).

To put things in perspective, we take two companies listed on S&P 500, say, Netflix and United Airlines(UAL). The market cap of the former is much larger than the latter. With lockdown and partial travel restrictions under imposition, people now have spent more time online. If we were to compare the impact of COVID on the businesses of both the companies and the subsequent impact of their businesses on the S&P 500, we would find that one gained significantly in the pandemic while the other suffered brutally. Netflix accounts for 0.83%* and United Airlines roughly about 0.03%* of the total value of the S&P 500 index. So the gains of Netflix would have a much larger impact on the value of the index than the losses of UAL. Thus, driving the total value in an upward direction in the market.

However, the losses incurred by many other companies are not visible on ‘wall street’ but they have had a drastic impact on the life of people living on ‘main street’ in the past few months. The kind of businesses affected by pandemic/lockdown-induced slowdown i.e, restaurants, entertainment providers, small food joints, parts of retail, etc., are not listed on equity markets. The job losses in those industries do not hold much significance to the investors and therefore the plight of the people on the main street is not visible on wall street. It surely has an impact on investors’ confidence in the initial few months of uncertainties, but due to the forward-looking nature of the markets, the bearish phase is short-lived. While in the real economy, the recovery process takes a lot of time.

It is indeed the ‘best of times and the worst of times.’ Best for some and worst for many. Economies will hopefully be fine again but thousands of people may probably not.

By Labeeb Hassan

Labeeb is currently pursuing his Bachelors in Economics at Hindu College. He has a yearning interest in reading and analyzing economic policies and is enthusiastic about being updated with the current geopolitical and governance issues impacting society.

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