Flow beats stock
The global economy is in the early stages of recovery after having faced one of the biggest shocks in 250 years. And even though it is becoming increasingly clear that the road to recovery will require considerably more time than the slump did, the markets continue their steady march upwards. Economists, in particular, sometimes struggle to understand this. But the explanation is probably simpler than it seems. It is a case of ‘flow’ beats ‘stock’.
A good example is the US labor market. The blue line in the graph above represents the total number of jobs in the US, excluding the agricultural sector, and the black bars represent monthly fluctuations in these jobs. To date, 14 million jobs have been lost since the Covid-19 outbreak in February – but at the same time, a staggering 7.5 million new jobs were generated in May and June.
This is the largest increase in the number of jobs that has ever been measured in the US. What is more, these figures were better than expected, and markets have shot up since they were published. The reason: a sound recovery, or even a V-shaped recovery, remains a distinct possibility for as long as there is change (flow) in the right direction and at a decent pace. Markets are exceptionally good at extrapolating positive figures; economists are less adept at this.
The same trend can be observed in a range of other indicators as well. A good example is global retail sales, which declined dramatically compared to a year ago. However, the most recent figures show sales exceeded expectations in a lot of countries. And, again, this change was on a historically large scale.
Central bank balance sheets are probably one of the most important stock-to-flow examples – although current stock-to-flow discussions about gold and bitcoin are also interesting. At present, it’s of less relevance whether the size of the balance sheet matters more than the rate of expansion. Central bank balance sheets are currently unparalleled, both in terms of their size and the rate at which they are expanding.
Fiscal budgets paint a similar picture. Governments are currently offering unprecedented support with national debts already at record high. If this support continues (flow), there is cause for concern in terms of what this means for markets in the long term.
In a nutshell, current market sentiment is responding to changes in economic indicators rather than to their actual levels. And that could also be the crux of the problem. It is not very probable that the magnitude of these positive changes will last. The low-hanging fruit has already been plucked and it is unlikely that governments and central banks will continue to offer their support if another economic setback occurs.
This is why some caution needs to exercised with respect to stocks – although I do believe economic recovery will continue. Flows can disappoint at times and for quite a while. For the record, economists find this easier to understand than the markets do.