Financial markets have continued to move higher over the last couple of weeks and we wanted to share our thoughts on why we’re starting to see financial markets continue to push higher, when the economy is, by and large – both domestic and global – still working through a lot of the challenges of COVID-19.
This chart compares where we were in the early part of the year to where we are today. You can see on the left-hand side that by and large in January, the broader economy was in pretty good shape. We had unemployment at multi-decade lows and strong consumer behaviour.
Equally, we had financial conditions that were allowing for an uptick in the performance of financial markets through the early part of 2020 and beyond. The S&P 500, along with the ASX 200, reached all-time highs in the early part of the year, and financial conditions – whether it be in terms of interest rates, which were at multi-decade lows at that time, liquidity in financial markets, which was very high, and market volatility – the risk associated with the markets was actually very low.
So it was really a perfect environment for strong financial market performance. But as the worst of COVID-19 began to hit, not only in the US but around the world, we saw that change quite dramatically. Through the months of February and March particularly, the financial markets became very stressed and the outlook for financial markets, akin to what we’re seeing in the real economy, started to converge. That resulted in a significant sell-off, particularly in risk assets through the months of February and March.
While the real economy continues to struggle through the worst of the pandemic, it looks like we have a very quick snapback in financial market performance. In our view, there were probably a couple of key reasons for this.
Firstly, we saw central bank intervention in a significant manner. The US Federal Reserve cut their official rate from 1.75% all the way down to 0.25%. Domestically, we saw the RBA move from a cash rate of 1% down to 0.25%. Equally, central banks have been very conscious of ensuring that markets can continue to function in a normal manner. So we saw significant levels of liquidity come into financial markets, and that ultimately helped investor confidence and reduced the overall level of market volatility. Central banks have also provided other mechanisms in terms of supporting financial markets, as well as ensuring liquidity and the well-functioning of those markets. In our view, that will continue to be the case as we move through the rest of this year and we don’t expect any change in the official interest rate outlook over the next 12 to 18 months.
Supporting what we saw in central banks, governments around the world introduced significant fiscal packages. We saw a significant amount here locally, as we did in the US and in Europe, as well as the rest of Asia.
These two aspects combined provided a really strong backdrop to financial markets and in our view financial markets are now starting to focus on looking forward once the recovery starts to take hold through the second half of this year. That’s why we’ve started to see that that sharp snapback in the equity markets, particularly from the March lows.
Now in our view, equity markets may have got a little ahead of themselves – and over the last couple of days, we’ve clearly seen some pullback. We wouldn’t be surprised if we continue to see some level of consolidation at these current levels. But it does highlight that financial markets are always trying to be forward-looking relative to the rest of the economy. Ultimately, in time, you would expect them to continue to have behavioural patterns as we saw back in the early part of the year, which reflected an economic environment that was consistent with the outlook for financial markets. Certainly, as the economy starts to reopen, we believe we will start to see a normalisation of the way corporates can look to deliver their goods and services, with people moving back into their employment positions as they were previously.
But that’s going to take a significant amount of time, there’s no doubt about that. We expect in many instances we’ll be still seeing a number of the challenges through 2021 and beyond. But the intervention that we’ve been seeing has been positive for financial markets and in terms of the positioning of portfolios.
As always, if you have any concerns about your portfolio, please feel free to reach out to your advisor.
Piers Bolger is Chief Investment Officer at Viridian Advisory
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