23 July 2020


By Raul Elizalde

This article also appeared on forbes.com

The Federal Reserve and the U.S. Treasury injected a massive amount of liquidity that is now sloshing around the U.S. economy. While the intention was to direct all this money to people and businesses affected during the pandemic, a lot of it is finding its way elsewhere. This is a major reason why the stock market is back to where it started the year, despite a barrage of bleak economic numbers.

We wrote before about how quickly the market rallied from the bottom in March, mirroring the speed at which it fell before then. Just like during the strong rebound in 2009, investors are having a hard time trusting this rally. It is indeed counter-intuitive that stocks could be unchanged for the year when economic activity tanked due to the Covid-19 pandemic.

A recent report by RBC, for example, finds the rally “puzzling”, just as they found it a month ago when they called for a 15% decline in the S&P 500 for the year. They are now reluctantly raising that forecast to a 10% decline - a level of 2900 - but they stress that other than adjusting the year-end target “nothing in our messaging has changed”, and that valuations “are frightening.”

One can sense the frustration of the report’s authors who, like many other analysts, have a hard time reconciling the fact that U.S. stocks are back to where they were when they started the year while GDP shrank by 5% in the second quarter and is widely expected to shrink by a far-worse 30% in the second. If stocks are supposed to reflect the outlook on company earning, this does not seem to make sense.

One explanation for the resilience of stocks is that, as sharp as the contraction may turn out to be, the consensus is that the stimulus packages will turn things around fairly quickly. Many studies support this, as we explored in a previous post.

There is no doubt that the monetary-fiscal stimulus has been huge. But its effect on stocks seems due to growing evidence that it has ended up on the balance sheets of stock market investors rather than in the pockets of those to whom it was originally intended.

The delivery of financial help has been widely panned as inefficient, for example by the inability of states to provide quick or adequate unemployment insurance, especially Florida, or by the delivery of emergency loans to entities that do not need them. Possibly the most egregious example of funds going to the wrong place is the libertarian, anti-tax Ayn Rand Institute. In their website they explain that the only ones who have a right to receive those funds are those who, like them, are fundamentally opposed to such system of “redistribution.” In their view, they are simply “reclaiming” taxes taken from them “by force.”

It didn’t have to be this way. The UK, for example, set up a system whereby the government pays 80% of each laid-off worker’s wages up to £2500/mo, as long as the business rehires that worker with a leave of absence. The result? UK’s unemployment rate is merely 3.9%. Germany adopted similar schemes.

A back-of-the-envelope calculation shows that if the U.S. had adopted a similar system for 18mm workers receiving unemployment, it would have spent $60BN per month, or less than $200BN per quarter. That more than $2TN were spent and still the unemployment rate in the U.S. is in double digits begs the question of where the money went.

The figures are staggering. Federal outlays far surpass anything seen in the U.S. in recent decades, and the Federal Reserve balance sheet is now about twice as large as it was during the aftermath of the financial crisis.

source: Federal Reserve Bank of San Francisco

source: Federal Reserve Bank of San Francisco

It seems clear that much of this money found its way to the financial markets. According to Refinitiv/Lipper, mutual funds and exchange-traded products received a net inflow of $860bn during the first half of 2020, and this does not even include purchases of individual stocks by individual investors.

The equity rally since the lows of March may seem in conflict with the sharp economic contraction, but it reflects the inefficient delivery of government stimulus. Instead of going to the most affected individuals and businesses, a large portion ended up in the financial markets instead. This is not about to change. The benefit of that inefficiency will continue to accrue to those who own stocks.

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