Are we dealing with Pavlovian markets in the equity markets?
Historically, Wall Street has tended to respond positively to countercyclical monetary and fiscal policies. This is not surprising. After all, this is what the Keynesian economics textbook is all about, combined with rational expectations: when the private sector spends less, the public sector should borrow to spend more. Rational markets should expect such countercyclical behavior to stabilize the economy. Wall Street is reacting faster and faster to countercyclical policies, as if it were confident that past experiences are a reliable guide for the future. In the context of the Covid-19 crisis, the response time of the US and global stock markets to the implementation of countercyclical monetary and fiscal policies has shortened significantly. Markets appear to be gaining a conditional response in which mere political announcements seem to be more important than the effective, successful and sustainable implementation of announced plans.
The gains in the stock markets since March 23 surprised and confused many experienced investors. Indeed, it happened with the release of data showing the steepest and deepest recession since the Great Depression. Admittedly, stock markets have a well-known tendency to climb up and hit bottom months before the real economy recovers. However, this time around, the level of uncertainty appears to be extremely elevated given the unique nature of the crisis. Equity markets behave as if there is no downside risk in the current situation. Undoubtedly, this is a testimony to the credibility of monetary and fiscal decision makers who have clearly demonstrated, especially in the US, the readiness to do “too much, too soon” and not “too little, too late”. It seems that US policymakers, who are usually the first initiators, have become so credible in the minds of global markets that they are able to elicit a Pavlovian conditioned global ‘buy’ response to an announcement of what will be done. By adopting this attitude, policy makers master the level of managing expectations. At the same time, at least partially, they have relieved themselves of having to put money where their mouths are. For example, the Federal Reserve has so far spent very little money buying corporate bonds, which was announced as a real breakthrough. However, corporate spreads have narrowed since the Fed announced on the subject.
The same is true of fiscal policy which, given the genuinely exogenous nature of the current crisis, has a greater role to play than usual. The state of fiscal policy is commonly assessed by expressing the budget deficit and public debt as a percentage of GDP. However, since the US federal government does not own US GDP, the ratio of federal debt to tax revenue and the ratio of tax revenue to expenditure seems more appropriate for assessing the fiscal stance (in order to eliminate seasonality in federal revenue and expenditure, we calculate the 12-month moving sum of these monthly time series). The higher these indicators, the more proactive is the fiscal policy. In April, the ratio of tax receipts to expenses decreased from 77.4 to 62.8%, while the ratio of the federal debt to tax revenues increased from 666 to 765% (!). This was primarily due to increased spending, but also due to a collapse in tax receipts (+ 21% and -3% respectively in the twelve months to April 2020 compared to the twelve months to April 2019: + 160%) and -55% in April 2020 vs April 2019). Surprisingly, the federal government has not used up its large cash balances ($ 1,050 billion as of March 4) since early March. On the contrary, it increased it by $ 381 billion. With this relative restraint in mind, it is striking that in the current recession, unlike the previous six, the S&P 500 immediately embraced increased fiscal wastefulness. Admittedly, the question is whether our way of measuring fiscal stance may be flawed because it implicitly believes that falling revenues is equivalent to increasing spending. However, from the point of view of the balance of savings and investment, they are definitely equivalent: both contribute to balancing the growth of private savings. And in the past, revenues have tended to be more cyclical than cover expenses: they don’t need any new legislation to collapse in a recession. Moreover, the time reduction in Wall Street’s response time to countercyclical policy is not limited to fiscal policy. This also applies, albeit to a lesser extent, to monetary policy.
Table: S&P 500 response time to fiscal expansion
Recession data are provided by N.B.E.R. Until the bottom of the market, the 9-month moving low of the S&P 500 index. The rally begins in the month following the month in which the S&P 500 is at the same level as its 9-month minimum. To determine the date of fiscal expansion, we apply a 9-month moving minimum debt to tax revenues and the ratio of revenues to expenses.
Table: S&P 500 response time to monetary easing
Recession periods are given by N.B.E.R.
Until the bottom of the market, the 9-month moving low of the S&P 500 index. The rally begins in the month following the month in which the S&P 500 is at the same level as its 9-month low. Up to the date of commencement of monetary easing, the 9-month moving maximum of the Federal Funds target rate.
The markets have rebounded very dynamically and policymakers in the US, especially on the fiscal side, are in the position of a poker player who has yet to show his hand and keep his promises. Among the many factors that can complicate the ‘hand checking’ process is how to distribute the burden of the crisis over capital and labor and the risk of financial bubbles exploding.
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