In this note, we contend that the global share market rally, which has been primarily US equity market driven, has thus far been entirely driven by central banks. The next phase will need to be driven by actual earnings and the real economy if it is to be sustained, and that will be a much trickier task.

Mission Accomplished

The Fed’s actions in March and April, note just in terms of size but in terms of scope, and way before the real economic impact of the coronavirus could be reliably forecasted, have propelled US equities by 11.3% on a rolling 1 year basis, as at end of May.

Mission accomplished? In terms of monetary stimulus (Figure 2), and the levers this central bank has at its disposal – the Fed may well think so – given we appear to have seen the peak in unemployment figures (Figure 1), and equity markets have rallied handsomely, bringing with it a degree of confidence. 

Figure 1: US Unemployment Rate ticks down in May 2020 from April Peak (source: Refinitiv Eikon)

Figure 2: Fed Balance Sheet Asset growth (source: Refinitiv Eikon, Resonant Calculations)

But how much of this rally is explained by the Fed's actions, as opposed to increasing optimism, earnings, or corporate actions such as buy-backs?

To understand the future, as investors we need to understand the past. 

Resonant’s framework uses four factors, sentiment, corporate actions, growth, and rates.

In breaking down on the index level returns, Resonant decomposes price returns into four categories (figure 3):

Sentiment (SENT): Are investors feeling more or less confident about the outlook for the economy and shares? Sentiment and confidence plays a key role in bull markets.

Corporate actions (CORP): Have companies been buying back shares (positive) or raising equity (negative)? Buy Backs increase earnings per share, and raising decrease earnings per share. This lever is particularly relevant for Australian Equities.

Growth (GROWTH): Have companies been growing the bottom line? Typically if the economy is growing healthily then this will feed through to earnings, and through to the index.

Rates (RATES): Has the Central Bank been incrementally more supportive of risk assets? We use bank bill futures where possible, to incorporate fluctuations not just in the base rate, but in the banks’ collective willingness to lend.

The four components are additive – so for the most recent reading, the price return of 11% on the MSCI US index has been driven uniquely by Rates (+48%), counteracting Sentiment (-21%), Growth (-15%). This suggests that without Fed Support, the Equity market would have fallen -37% on a rolling 12 month basis as at end of May!

Figure 3: 4 factor breakdown of US Equity Returns (source: Refinitiv, Datastream, IBES, MSCI, Resonant Calculations)

The key takeaway from this chart is that this is a "risk-off rally" – the sentiment contribution (SENT) is negative for the 12 months leading to May 2020, which is an unusual state of affairs, and probably why so many professional investors are feeling uncomfortable.

The only other year  since 1997 in which the contribution from sentiment was negative, and the market rallied is 2009-2010, which was driven by significant earnings growth as the economy came out of the great recession.

If indeed the most significant Fed monetary policy actions are complete then the baton will shift to earnings (GROWTH) – and these are potentially only currently reflecting a short lived recession, and nothing as deep as was experienced in 2008.

This may prove more challenging for US companies to achieve these sell-side earnings forecasts over the next 12 months.

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