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By Ian Riach and David Andrews, Franklin Templeton Canada
(Sponsor Content)
Equity markets that bear little resemblance to the wider economy has been one of the major investment stories of 2020. It has been an historic year, marked by some wild swings in stock valuations, and with the prospect of much more volatility to come. The U.S Presidential Election in November looms large on the horizon, not to mention the small matter of COVID-19.
The coronavirus has devastated the world economy; in its most recent forecast, the IMF predicted a global economic contraction of 4.9% for 2020. To put that number in perspective, such a downturn would represent the worst annual decline since the Great Depression of the 1930s.
Equity markets tell a different story, and stocks have rallied strongly since the bear market lows of March this year. In fact, U.S. equities reached record highs with the S&P 500 up more than 21% on a one-year basis at the end of August.
This disparity has brought the relationship between stocks and the overall economy into sharp focus in 2020. While both the U.S. and Canada posted some positive job numbers in August, unemployment remains high (10.2% in Canada; 8.4% in the U.S.) and the stimulus measures that kept the economy afloat during the lockdown will not continue indefinitely. Then there is the virus itself to consider, particularly the threat of a second wave that is even more devastating than the first, which is what happened with the Spanish Flu of 1918–1920.
The economy is precarious
The economy is clearly in a quite precarious position and some areas (tourism, hospitality, air travel) could take years to recover, if at all. It does seem logical to presume that stock market performance and economic conditions should go hand in hand — economic growth resulting in higher corporate profits and in turn, higher share prices.
Often that is not the case, with a low, and sometimes even negative, correlation between stock market returns and GDP throughout history. Despite Donald Trump’s assertion that everything is fine when the stock market goes up, the stock market is not the economy.
Stock markets, represented by indices such as the S&P 500, are comprised of a very select group of firms that are publicly traded. Most indices are market cap weighted, which means larger firms have more of an impact on overall index movements — think of the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks and their influence this year.
The chart above displays just how influential large stocks can be on an index. Year to date, the S&P 500 has a positive return but only because of strong returns by the FAANG stocks. The ‘other 495 stocks’ have not fared nearly as well as the index would imply. It is clear that a few companies have benefitted from the fallout of the COVID-19 pandemic, but most have not.
The problem with such a small number of companies having such an oversized influence on the markets became apparent as a drawdown among the big tech names saw the Nasdaq Composite plunge 10% and the S&P 500 lose 7% in a three-day period either side of Labour Day.
Stocks reflect future economy rather than present one
It is the nature of stock markets to be forward-looking as they attempt to reflect the future economy rather than the present one. Since the spring, markets have been boosted by massive injections of liquidity by central banks, large government support programs, as well as a realization that pandemics are temporary rather than permanent. All this ‘new’ money must go somewhere and much of it found a home in stocks, specifically larger cap tech stocks, inflating valuations.
Taking this all into account, a disconnect between the present-day economy and forward-looking stock markets is not that unusual. The magnitude and speed of the recovery this time round has been pretty unique, but given the unprecedented fiscal and monetary stimulus, it’s not all that surprising in retrospect.
Ian Riach joined Franklin Templeton in 1999 and is a senior vice president and portfolio manager for Franklin Templeton Multi-Asset Solutions (FTMAS) and is a member of the FTMAS Investment Strategy & Research Committee. He has portfolio management responsibilities for all Canadian-based multi-asset products including the Franklin Multi-Asset ETF Portfolios, Franklin Quotential Portfolios, Private Wealth Pools, and Franklin LifeSmart Portfolios. He is also responsible for Institutional Balanced Portfolio Management. As the Chief Investment Officer of Fiduciary Trust Canada (part of Franklin Templeton Investments), Mr. Riach also oversees the investment management of Franklin Templeton’s private wealth business. A 32-year investment industry veteran, Mr. Riach holds a bachelor of commerce degree from the University of Calgary and is a Chartered Financial Analyst (CFA) Charterholder.
David Andrews joined Franklin Templeton in 2015 and brings over 20 years of industry experience to the FT Multi-Asset Solutions (FTMAS) team in Canada. In his current role as Client Portfolio Manager (CPM) David is responsible for designing, engineering, and managing customized investment solutions for clients across Canada. He is an active participant in our Investment Strategy Research Committee, and he represents the FT Multi-Asset Solutions team in meetings with existing clients as well as with new business opportunities. David is a graduate of Wilfrid Laurier University, where he majored in both Economics and Sociology. He is a Chartered Financial Analyst (CFA) charterholder.
This commentary is for informational purposes only and reflects the analysis and opinions of the Franklin Templeton Multi-Asset Solutions (FTMAS) investment team as of September 9, 2020. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.
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