Monthly Market Wrap

12 Rounds with a Global Pandemic: A Story of US Federal Reserve Liquidity

A question we have been fielding often over the past few months is “why have stock markets been performing strongly during the poorest economic conditions we have seen in decades?” The answer to this question is not as simple as we would like. The response to the COVID-19 crisis has been multi-faceted and global. Along with the massive public health response, there have been significant fiscal (government) and monetary (central bank) responses globally.

While it is not possible to cover the entirety of fiscal and monetary policy responses that we have seen in individual countries in this short note, we can illustrate why monetary policy has buoyed markets through looking more closely at the US Federal Reserve. As the COVID-19 crisis began to take hold in the US, the first step the Federal Reserve took was to cut the cash rate to a range between 0.00% and 0.25% to reduce funding costs. The Fed’s second step was to buy a significant amount of US Government bonds. Quantitative easing, which is the printing of money by the Fed to purchase Government bonds, has been used extensively by the Fed since the Global Financial Crisis. What is different this time, is that rather than only purchasing Government bonds, the Fed has purchased a significant amount of Exchange Traded Funds (ETFs) that track US corporate debt markets.

The effect of the quantitative easing that the Fed has undertaken is a reduction in effective yield, or interest, payable on Government bonds as well as corporate bonds. This had three intended outcomes in mind:

1.       To reduce the attractiveness of purchasing or holding Government debt;

2.       To increase liquidity in corporate debt markets to avoid a “credit crunch” where corporations are unable to rollover their debt; and

3.       To keep costs of corporate borrowing as low as possible.

Focussing on the first goal, to reduce the attractiveness of purchasing or holding Government debt, the outcomes achieved by this are quite simple. Institutions hold trillions of dollars in US Government debt at any one time. Investment managers, when faced with yields on bonds that do not warrant holding those assets, need to put those assets elsewhere. The cash rate, being 0.00% to 0.25%, means that returns in bank accounts are almost non-existent. This leaves only growth asset classes as being appropriate investments for these managers. As that money has come out of bonds, it has moved into equities, pushing equity prices upwards. As you can see in the graph (over page) as the US Federal reserve has increased their balance sheet (RHS), you can see that the S&P 500 has similarly rallied. Whilst this does not explain the entirety of equity market gains over the past 4 months, it does explain a significant portion.  

June Market Recap

In Australia, the ASX 200 rose 2.47% in June. Unfortunately, this did not make up for the poor performance in recent months, as the ASX 200 fell 11.28% over the 2019/2020 financial year.  The true economic reality for listed Australian businesses will become known over the next few months as companies report their annual results. Incredibly strong performers for the month include Breville Group (+29.61%); Resmed (+16.10%); and JB Hi Fi (+15.92%).

In the United States, markets performed strongly again. New job creation surprised to the upside and there are signs that the US economy is recovering. However, as we begin to see government responses to second wave outbreaks the picture will become clearer. The tech-heavy Nasdaq index appreciated by 6.29% during the month as investors place more faith in tech companies’ ability to weather the COVID-19 crisis. It has also been supported by so-called “Robinhood” traders. Robinhood is a brokerage that is dominated by Millennials and provides free brokerage. Brokerages in the US are able to offer free brokerage as they sell the order flow to hedge funds who then either front-run (buy prior to placing the orders so that the orders increase the value of your earlier position) or use the order flow for high-frequency trading strategies. The Dow Jones Index was up 1.69% for the month and the S&P 500 was up 1.84% in June.

In Asia, the Japanese Topix index fell slightly by 0.35% and the Shanghai Composite Index was up by 4.64%. Since the end of the month, the Shanghai Composite index has rallied by around 10%. Geopolitical threats are growing in Asia as China adopts greater security controls over Hong Kong and continue their aggression in the South China Sea. Hong Kong risks losing its position as a financial hub due to China’s actions.

European markets continued their bounce back. The German DAX rose 6.25%, the French CAC 40 rose 5.12%, and the UK FTSE 100 rose 1.53%. The German manufacturing sector continues to improve and should help to prop up those countries that fit into the supply chain of their manufacturing powerhouse.