Author Archives: Jesper

The global cost of the crisis

Based on IMF forecasts, I calculate the global cost of the crisis as foregone (because of the pandemic) global economic activity up until 2024. The cost amounts to USD 23,600bn, a quarter of global output in 2019. The cumulative output loss is almost twice as large in developing and emerging economies as in advanced economies, though China is an outlier. The calculation represents a lower bound on the final cost, as economic activity might not recover until 2024. Also, the calculation does not include health-induced costs, the inclusion of which would further increase the cost.

As the final (at least for the time being) part of my analyses of the cost of the crisis (link and link), I present here my calculation of the global cost of the crisis.

Continue reading

The cost of the second wave

Early December 2020, I presented my calculation of the expected cost of the corona crisis in Denmark, taking into account both economic and health-related costs (link). Since then, the situation has turned to the worse, and the expected cost of the crisis has increased by something like 50%. The calculation here is done for Denmark, but given similar types of waves in the US, the UK, and many other countries in Europa, I would expect similar types of consequences.

Continue reading

2020

It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

Continue reading

The cost of this crisis

The corona crisis has caused a loss of economic activity. To calculate the total economic cost of this health-induced crisis, we must factor in health-related costs. Based on calculations for the US by Cutler & Summers, this post calculates the economic cost of the crisis in Denmark. Many uncertainties surround such calculations, and I discuss those. It seems a robust conclusion, though, that the cost of the crisis in Denmark will be considerably smaller than the cost of the crisis in the US. The broader implication of this result is that there is considerable variation across countries in the economic cost of the pandemic.

Continue reading

VV or W: When did (or does) this recession end?

This corona recession started in February 2020. Officially, it is still ongoing. But, perhaps, it has in fact already ended. This might seem confusing but it helps explaining the performance of financial markets during this “recession”.

In my soon-to-be-released book From Main Street to Wall Street (link and link), I – among many other things – carefully examine the historical relation between the business cycle and financial markets. I verify that stock markets typically perform considerably better during expansions than recessions. In the book, I examine and explain why this is so. I also explain that this is not a bulletproof finding. It is not always so. Sometimes stock markets do fine during recessions. Is this recession one of them?

Continue reading

If Biden wins

If history is any guide, it will be four good years on the stock market if Biden wins on November 3. Historically, stocks have performed so much better under Democratic presidents. The question is whether history will be a guide also this time around.

Are Democratic or Republican presidents better for the stock market? To evaluate, let us recall the performance of the US stock market under Trump – a Republican – and compare it to its performance under Obama – a Democrat and Trump’s predecessor. Afterwards, let us look at the full history of the stock market under Democratic and Republican presidents. Finally, let us discuss what it implies for this election and the next four years on the US stock market.

Continue reading

Expected returns, autumn 2020 updates

Today, October 1, the Council for Return Expectations publishes its updated expectations. We expect very low – negative – returns on safe assets over the next five and ten years. We expect an equity premium around 5-7 percent.

I chair the Council for Return Expectations (link). Twice a year, we update our expectations. Today, we publish our latest forecasts.

In a June post (link), I described the history of the council, how we operate, who we are, why we publish expected returns, what they are used for, and so on. Briefly, here, the Council consists of Torben M. Andersen (professor of economics, University of Aarhus; link), Peter Engberg Jensen (former CEO of Nykredit and current chairman of Financial Stabilitet; link ), and myself as Chairman. Based on inputs from Blackrock, J.P. Morgan, Mercer, and State Street (thanks!), we estimate expected returns, risks (standard deviations), and correlations between returns on ten different asset classes over the next five and ten years. We also publish expected returns on two assets classes (stocks and bonds) for investment horizons exceeding ten years.

The forecasts are important in Denmark. When Danish pension funds project how the retirement savings of their customers will most likely develop (with confidence bands), they base their projections on the Council’s return expectations. Similarly, when banks advice Danish investors on their non-retirement savings, they use the expected returns provided by the Council. I think it is fair to say that Denmark has been a front-runner in designing a system where banks and pension funds do not compete on expected returns, but all use a common set of return assumptions, determined by an independent Council.

The forecasts published today will be used for pension projections and projections for savings outside retirement accounts as of January 1, 2021. In spring 2021, we will publish updated expectations that will be used from July 1, 2021, and the following six months. And so on.

The timing is as follows. The expectations we publish today are based on market data from July 1, 2020. We use the period from July 1 until today (October 1) to determine our expectations. The expectations we publish today are then used by banks and pension companies as of January 1, 2021.

The numbers

We publish forecasts for expected returns on ten asset classes over the next five years, years 6-10, and over the next ten years. Returns are average annual returns in Euros/Danish kroner (the Danish kroner is fixed to the euro). These are our expectations:

Source: Council for Return Expectations

We expect an investment in safe assets (defined as a five-year duration portfolio of 30% Eurozone government bonds (minimum Triple-B), 20% Danish government bonds, and 50% Danish mortgage bonds – Danish mortgage bonds are triple-A rated, by the way) to lose money every year on average over the next ten years. This is noteworthy. On average, we expect such an investment to lose 0.1% per year over the next ten years. Over the next five years, we expect it to lose 1.2% per annum. The reason why we expect such low returns is that the underlying bond portfolio has a duration of five years, as mentioned, and we expect a normalization of interest rates, causing capital losses which drag down expected returns.

We expect lower returns from bond investments than we did in our June update (link). In June, we expected government and mortgage bonds to return a negative 0.3% per year over the next five years and a positive 0.3% per year over the next ten years. The reason why we expect lower returns now (-1.2% and -0.1% for the five and ten year periods, respectively) is that our forecasts today, as mentioned, are based on market data from July 1. On July 1, interest rates and credit spreads were lower than those used at our previous update. Our previous update was based on March 31 market data. In March, the corona virus had caused a hike in yields and a widening of credit spreads. Since then, yields and spreads have come down.

Global equities are expected to yield around 6% per year. This means that the equity premium is expected to be 5%-7%, depending on the investment horizon.

We expect low inflation. We expect Danish inflation to be 1.2% per annum over the next five years and 1.5% over the next ten years.

For investment horizons above ten years, we expect equities to return 6.5% per annum and bonds 3.5%. This is the same as we expected last year (we update long-run expectations once a year). Over the coming year, we will make a thorough evaluation of these long-run expectations.

We also publish standard deviations for all asset classes and for all horizons, as well as correlations and fees. Standard deviations are high for high-return assets; nothing comes for free. We thus publish many numbers. You can find all these numbers on the webpage of the Council: link.

Conclusion

We (The Council for Return Expectations) expect that Danish investors will lose money – even before fees and inflation – if investing in safe assets over the next ten years. You can expect positive returns on other asset classes, but then you need to take on risks.

Historically, the risk-free real interest rate has been around 2% per annum and the nominal interest rate around 4%. Investors would see their savings grow, even without taking on risk. This is not what investors should expect going forward. The fact that you cannot expect your portfolio to grow without taking on risk tells us a lot about the low-return world we are living in.

Quantitative Easing (QE) and biases in research

Do asset purchases by central banks raise economic output and inflation? An interesting new paper finds an affirmative answer, but also – and this is the main point – that the size of the effect depends on whom you ask. If you ask central bankers, they will tell you that the effect of QE is large. If you ask independent academic researchers, they will tell you it is considerably smaller. This difference indicates that central-bank research on this topic might be biased. It also indicates that Quantitative Easing is probably not as effective as we are told.

One of the defining characteristics of financial markets since the financial crisis in 2008 is the use and influence of “unconventional policy tools” by central banks. As monetary policy rates have been close to zero, central banks have been unable to stimulate the economy via even lower interest rates. Instead, central banks have started purchasing financial assets, mainly government bonds. These alternative policy tools are labelled “asset purchases by central banks”, or simply “Quantitative Easing (QE)”.

Quantitative Easing increases the demand for government bonds, thereby raising their price and bringing down their yields. When yields on government bonds fall, other yields in the economy, such as yields on mortgage bonds, fall, too. This should promote economic activity and raise inflation, central banks argue.

Quantitative Easing is not uncontroversial, though. In several of my posts (link, link, and link), I have argued that it raises other asset prices in the economy, such as stock prices. Some fear that this induces bubble-like behavior in asset prices. Also, QE might distort signals from asset prices, causing unclear signals from prices about the underlying state of the economy and financial markets. In addition, by raising other asset prices, Quantitative Easing might contribute to increasing inequality, as financial assets are typically held by the already wealthy. On the other hand, if QE helps promoting economic activity, it helps reducing unemployment among low-income groups, which should reduce inequality, central banks argue in return (link). In the end, then, to justify Quantitative Easing, it should have a sizeable impact on inflation and output, outweighing the potentially negative effects on other parts of the economy.

Many papers have analyzed the effects of quantitative easing. A brand-new paper (link) summarizes these analyses and asks the question whether results are more positive when central bank economists analyze QE. Given that central banks influence public opinion, the latter question is important when we evaluate the most significant policy intervention during the last decade.

There are two reasons why I think this paper is particularly interesting. First, it summarizes research on QE in a neat way. It concludes that QE is effective, but not as effective as we are often told. Second, it emphasizes the importance of independent academic research. As the faculty representative on the Board of Directors at Copenhagen Business School, stressing the importance of academic research, I find this to be an important conclusion, too.

To avoid any misunderstandings about my own view, let me stress two things before getting to the results.

First, I believe that targeted central bank intervention can be useful. In my last post, I describe one monetary policy intervention that clearly fulfilled its goal (link). During a crisis, if markets are malfunctioning, there can be good reasons for policy interventions. On the other hand, I am skeptical towards the view that the advantages of endless asset purchases by central banks outside crisis periods outweigh their disadvantages. This paper indicates that QE is less powerful than central bankers tell us, lending some support to this view.

Second, my point here is not to say that central bank research is suspicious in general. On the contrary, I strongly recommend central banks to invest in economic research. I believe that better decisions are taken when based on solid academic analyses. So, central banks should be encouraged to invest in research, but their own evaluations of their own actions are probably not unbiased.

The study

Brian Fabo, Martina Jancokova, Elisabeth Kempf, and Lubos Pastor (link) study 54 analyses, written/published between 2010 and 2018, of the effects of quantitative easing in the US, the UK, and the Eurozone. 57% of the papers have been published in peer-reviewed journals. 60% of the authors are affiliated with central banks.

Lubos Pastor and co-authors collect estimates of the effect of QE on economic output and inflation across the 54 studies and report the average (and median) effects. They also investigate whether the reported effects are different if a study is conducted by central bank researchers.

Bias in central bank research

Pastor et al. list five reasons why central bank research might be biased (directly taken from the paper, page 2, here):

  • ”First, the economist may worry that the nature of her findings could affect her employment status or rank. Is she less likely to get promoted if her findings dent the bank’s reputation? Could she get fired?”
  • ”Second, the economist may be unsure whether her research will see the light of day. Bank management could in principle block the release of studies that find the bank’s own policy to be ineffective, or to have undesirable side effects.”
  • ”Third, the economist may suffer from a confirmation bias (Nickerson (1998)). A central bank employee may believe a priori that the bank’s policies are effective, and she may select evidence supporting her prior.”
  • ”Fourth, the economist may care about the bank’s reputation.”
  • ”Finally, the economist may care about her own reputation if she is senior enough to have participated in the formation of the bank’s policy.”

The findings

The main findings of the paper are collected in this graph:

Source: Fabo, Jancokova, Kempf, and Pastor (2020)

Pastor et al. report that a QE-program at its peak, i.e. when a QE program has its maximum effect, on average (across the 54 studies) raises GDP by 1.57% and the price level in the economy by 1.42%, as indicated by the blue columns in the graph (”Average all studies”). This seems to be relatively large effects, I would say.

Do these effects depend on the affiliations of researchers? Pastor and co-authors find that central-bank affiliated researchers report significantly larger effects. If counterfactually changing the share of central bank researchers in a study from 0% to 100%, the peak effect on output is estimated to be 0.723%-points larger and the peak effect on the price level 1.279%-points larger. I illustrate this in the figure above as the “Effect of CB authors”. Compared to the overall average effect, the effect of central-bank authorship is large. For the price level, going from 0% to 100% central-bank authorship almost corresponds to the total average estimated effect of QE on price levels across all 54 papers . In other words, if you think central bank estimates might be biased, the ”true” average effect of QE programs is considerably smaller than the estimated overall average effect.

Pastor and coauthors report the average point estimate of all papers and the additional effect of central bank affiliation, as indicated in the figure above. They do not report the average estimate from papers written by central bank authors, respectively written by academic authors. I asked Lubos Pastor about this. In private email correspondence with Lubos and Elisabeth Kempf, they inform me that papers written by central bank authors (defined as papers with at least one central bank author) estimate a 1.752% peak effect on output. Papers written by academics (defined as papers with zero central bank authors) find a considerably smaller effect, 0.996%. For inflation, the peak effect on output is 1.791% for papers written by central bank affiliated authors. Academics estimate a much smaller effect, only 0.545%. In spite of massive asset purchases (we are literally talking trillions of dollars, euros, and yen), the average effect on inflation is small, at 0.5%, academics report. Less than a third of what central bank affiliated researchers report.

As academics, we are not only interested in the size of the coefficients/effects, but also whether effects are statistically different from zero. Pastor and coauthors report a striking finding here. While all papers written by central bank researchers find that QE has a statistically significant effect on output/inflation, only 50% of papers written by independent academics find significant effects.

Finally, Pastor and co-authors note that the German central bank (the Bundesbank) has been particularly skeptical towards ECB QE. So, what happens if you look at researchers affiliated with the German central bank? Bundesbank researchers find much smaller effects of QE. In fact, Bundesbank researchers find an even smaller effect of QE on economic output than independent academics. Again, this indicates that the preferences of an institution seem to influence the conclusions of its researchers.

The paper presents additional analyses, such as looking more closely at the mechanisms at play, i.e. career concerns, involvement of management in research, and so on. Read the paper if you want to know more about this.

Conclusion

I think the paper by Brian Fabo, Martina Jancokova, Elisabeth Kempf, and Lubos Pastor is interesting also because it summarizes what the average effect of QE is, based on a large number of studies. Across more than 50 papers, the average maximum effect of QE on GDP and the price level is around 1.5%. This is useful information in itself.

Some papers are written by central bank researchers and some by independent academics. It seems reasonable to hypothesize that central bankers might have a tendency to view their own policies in a more favorable light. This is what Lubos and co-authors find. They report that the effect of having central bankers as authors of an analysis is almost as large as the average reported effect of QE on the price level itself. In private email correspondence, they also tell me that the average effect, estimated in academic papers, of QE on the price level is only 0.5%, i.e. very small, almost negligible. This is of course a controversial result. I predict it will generate intensive debate.

The fact that I discuss this paper here should not be taken to imply that I am skeptical towards central bank research in general. In fact, I am sure the quality of monetary policy decisions is improved when central bankers have access to the latest research. Also, I have no reason to believe that central bank research on other topics than monetary policy should be biased. But, when it comes to assessing their own actions, researchers in central banks might be subject to certain biases. It requires some guts to tell senior management that the trillions they have spent on quantitative easing probably has not been very effective. Instead, it might further your career if you paint a rosier picture. This is important to recognize.

I view the bottom line as follows: QE probably has some effect, but its effect is considerably smaller than we are told by central banks.

The Fed’s “Whatever it takes” moment. Or, how the Fed saved equity and credit markets

Facing a looming recession and financial market panics, the Fed intervened heavily in late-February/early-March, lowering the Fed Funds Rate to zero and expanding its balance sheet dramatically. In spite of this, markets kept on panicking. Then, suddenly, on March 23, everything changed. Stock markets started their rally. This was not because the Fed lowered the rate or expanded its asset purchases even further, nor because the economic data improved. What happened? The Fed made an announcement. Nothing else. It is a fascinating illustration of how expectations can change everything on financial markets.  

Much has been written about the massive interventions of the Fed during February and early March. In my previous post (link), I list Fed interventions as one of the reasons why the stock market is back to pre-crisis highs. In this post, I dig one step deeper and explain the fascinating story of how the Fed said something and thereby rescued markets.

Asset purchases and rate reductions did not save markets in February/March

Let us start by illustrating how the actual Fed interventions (interest rate changes and asset purchases) did not save markets in March. The Fed lowered the (lower range of the) Fed Funds Target Range to 1% from 1.5% on March 2 and then again to 0% less than two weeks later, on March 14. At the same time, it bought Treasuries and mortgage-backed securities to the tune of USD 600bn per week. These interventions succeeded in lowering yields on government and mortgage-backed bonds, but did not cheer up stock markets.

This graph shows how Treasury yields came down significantly in February/March, by basically 1.5%-point (from close to 2% to close to 0.5%; I show yields on 10-year Treasuries in this graph), as a result of reductions in the policy rate (the Fed Funds Rate) and asset purchases by the Fed.

SP500 and yield on 10-year Treasuries. Daily data.
Source: Fed St. Louis Database

The graph also shows that the SP500 continued falling throughout February/March. In other words, the massive interventions by the Fed in late-February/early-March (and these interventions really were massive – buying for USD 600 bn per week and lowering rates to zero is indeed a massive intervention) did not convince stock markets that the situation was under control. And, remember, these were not minor stock-market adjustments. It was the fastest bear market ever (link).

What turned the tide?

On March 23, the SP500 reached its low of 2237, a drop of 31% compared to its January 1 value. Since then, everything has been turned upside down and markets have been cheering, as the above graph makes clear.

What happened on March 23? The Fed had its finest hour. It did not do anything. It merely said something. A true “Whatever it takes” moment.

As you remember, a “Whatever it takes” moment refers to the July 26, 2012 speech by then ECB-president Mario Draghi (link). The speech was given at the peak of the Eurozone debt crisis. The debt crisis pushed yields on Italian and Spanish sovereign bonds to unsustainable levels. Italy was too big to fail, but also too big to save. The pressure on Italy was a pressure on the Eurozone construction. Mario Draghi explained the situation and said the by-now famous words:

But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Investors understood that the ECB would be ready to buy sovereign bonds to save the Euro. Markets calmed down. Italian and Spanish yields fell. And this – and this is the point here – without the ECB actually intervening, i.e. without the ECB buying Italian or Spanish bonds. The announcement that the ECB would intervene was enough to calm down investors.

Why is this relevant here? Because on March 23 the Fed sent out a press release, announcing that:

“…the Federal Reserve is using its full range of authorities to provide powerful support for the flow of credit to American families and businesses.”

And, then, as one of the new features announced the:

Establishment of two facilities to support credit to large employers – the Primary Market Corporate Credit  Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.

This statement turned everything upside down. The important thing is that this turn of events happened without the Fed using any money at all. It was a “Whatever it takes” moment (though, perhaps not as Dirty-Harry dramatic as Mario Draghi’s “And believe me, it will be enough”): The Fed announced what they would do, investors believed the Fed, and markets started cheering. It is a prime example of how investor expectations influence financial markets.

What are the PMCCF and SMCCFs, why did the Fed announce them, and why were their effects so dramatic?

The lowering of the Fed Funds Rate and the purchasing of Treasuries succeeded in lowering yields on safe assets, such as Treasury bonds, as explained above, but did not lower yields on corporate bonds. In fact, during the turmoil in late-February/early-March, credit spreads (the spread between yields on corporate bonds and safe bonds) widened dramatically. When yields on corporate bonds rise, it becomes more expensive for corporations to finance their operations. And, when yields rise a lot, as in February/March, investors get nervous about the profitability and survival of firms.

This graphs shows how yields on both the least risky corporate bonds (Triple A) and speculative grade bonds (Single B) rose dramatically in relation to 3-month Treasury Bills, with yields on lower-rated bonds (Single-B) naturally rising more than yields on higher-rated (Triple-A) bonds.

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries as well as the difference between yields on ICE BofA Single-B US High Yield Index and 3-month Treasuries. Daily data.
Source: Fed St. Louis Database

The important point in the picture is that the spreads continued rising throughout late-February/March, in spite of the intensive interventions described above, i.e. in spite of Fed purchases of government and mortgage bonds. The Fed was happy that safe yields fell, but was concerned that credit spreads kept on rising. Volatility in corporate bonds markets also rose (link), making the whole thing even worse.

More or less all firms saw their funding costs increase, even when there were differences across firms in different industries, with firms in the Mining, Oil, and Gas, Arts and Entertainment, and Hotel and Restaurant sector hit the hardest, and firms in Retail and Utilities sectors less affected (link). The Fed became nervous because higher funding costs for firms affect firms negatively, causing them to cut jobs, reduce investments, etc.

The Fed decided to act. It announced on March 23 that it would launch two new programs, PMCCF and SMCCFs. The PMCCF is the ’Primary Market Corporate Credit Facility and the SMCCF the Secondary Market Corporate Credit Facility. Primary markets are where firms initially sell their newly issued bonds. The PMCCF should thus ease the issuance of newly issued corporate bonds, i.e. help firms raise funds. Secondary markets are where bonds are traded afterwards, i.e. the SMCCF should ease the trading (liquidity) of already existing corporate bonds.

The effect on equity and credit markets of the announcement of the PMCCF and SMCCFs was immediate and spectacular. Immediately after the announcement, credit spreads narrowed (see, e.g., link, link, and link).

Interestingly, stock markets reacted immediately, too. The stock market, thus, did not react to the lowering of the Fed Funds Rate and the extensive expansion of the Fed balance sheet in late-February/early-March, but reacted strongly to the announcement that the Fed would buy corporate bonds on March 23.

This (supercool, I think 🙂 ) graph shows developments on corporate bond and equity markets. The graph shows the spread between yields on AAA-rated corporate bonds and 3-month Treasury Bills and the stock market inverted, both normalized to one on January 1. The graph for the inverted stock market means that when the SP500 is at 1.45 on the y-axis on March 23, the stock price at January 1 was 45% higher than it was on March 23.

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The parallel movements in equity and credit markets are striking. Equity and credit markets moved in parallel during January, when stock markets rose and credit spreads narrowed, in late-February/early-March when credit spreads widened dramatically and stock markets fell like a stone, as well as after March 23, when both credit spreads and stock markets improved spectacularly. Since then, stock markets have continued to rise and credit spreads have continued to narrow.

The correlation between the two series is an astonishing 0.93 for the January 2 through May 31 period.

The announcement effect

The Fed has experience with and a mandate to buy mortgage-backed securities and Treasuries. It had no such experience when it comes to purchases of corporate bonds and corporate bond ETFs. This means that the Fed could not start buying corporate bonds on March 23, it needed an institutional set-up. It created an SPV with capital injections from the Treasury and leverage from the New York Fed, it asked a financial firm (Blackrock) to help them purchase the bonds, etc. These things take time. The Fed only started buying corporate bond ETFs in mid-May and corporate bonds in mid-June.

Given that the Fed only started buying bonds and ETFs in May/June, the spectacular turnaround on March 23 really was due to the announcement only.

In slightly more detail, it played out as follows. The March 23 announcement primarily dealt with higher-rated corporate bonds (Investment Grade), and spreads narrowed immediately. On April 9, the Fed announced that they would expand “the size and scope of the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF)”, buying bonds that were Investment Grade on March 22 but had been downgraded since then as well as corporate bond ETF. High-yield spreads tightened even more (link). Today, the Fed explains that the programs allow the Fed to buy “investment grade U.S. companies or certain U.S. companies that were investment grade as of March 22, 2020, and remain rated at least BB-/Ba3 rated at the time of purchase, as well as U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. corporate bonds.”

The actual purchases began in May/June, several months after the announcement. Interestingly, the purchases themselves have had a modest impact only. First, the amounts of corporate bonds and corporate bond ETFs bought pale in comparison with the amounts of mortgage-backed securities (MBS) and Treasuries bought. The Fed has bought MBS and Treasuries to the tune of USD 3,000bn this year. It has “only” bought corporate bonds and ETFs for around USD 12bn. The amount used to buy corporate bonds thus corresponds to less than 0.5% of the amount used to buy MBS and Treasuries. This graphs shows the daily purchases. Using the latest figures from August 10, the Fed has basically stopped buying corporates.

Daily Fed purchases of corporate bonds and corporate bond ETFs. Daily data.
Source: Fed webpage. Thanks to Fabrice Tourre for collecting and sharing the data.

So, the Fed has not bought a lot of corporate debt. It has, however, the power to buy a lot. The PMCCF and SMCCF set-up is such that the Treasury has committed to make an USD 75bn investment in the SPV that buys the assets (USD 50bn toward the PMCCF and USD 25bn toward the SMCCF). The New York Fed then has the ability to level this up by a factor of ten, i.e. the Fed can buy corporate debt for up to USD 750bn. This is a sizeable fraction of the total US corporate bond market. This, that the Fed can potentially buy a lot, helps making the program credible and thus helps explaining its powerful impact.

Dilemmas

Given the success of the PMCCF and SMCCFs, commentators have started arguing that the Fed should be allowed to buy corporate bonds as part of its standard toolkit (link). This might be relevant, but purchases of corporate bonds by central banks raise a number of dilemmas:

  • Keeping zombie firms alive. By easing up stresses in corporate bond markets, the Fed calmed down markets. This was the intention of the PMCCF and SMCCF announcements and it worked. It eased access to funding for firms, and firms have raised a lot of cash as a consequence (link). It is positive that malfunctioning markets are stabilized, but if central bank intervention makes markets too cheerful it may allow firms that in principle should not receive funding to nevertheless get it. And, thereby, to keep firms alive for too long, and increase firm leverage too much. Basically, the fear is that programs such as the PMCCF and SMCCFs create too many zombie firms. My CBS colleague Fabrice Tourre and his co-author Nicolas Crouzet has an interesting paper that examines this (link). Fabrice and Nicolas find that when financial markets work perfectly (no disruptions), Fed intervention might be detrimental to economic growth. On the other hand, if markets are disrupted, Fed intervention might prevent a too large wave of liquidations. One thus needs to determine when markets are disrupted “enough” to rationalize interventions in credit markets. This is no straightforward task.
  • Distributional aspects. By buying some bonds but not others, the Fed exposes itself to the critique that it helps some firms at the advantage of other. To alleviate such criticism, the Fed has been very transparent and publishes a lot of information about the bonds it buys, the prices at which it buys the bonds, etc. (link). Nevertheless, it is easy to imagine that some firms at some point will start saying ‘Why did you buy the bonds of my competitor, but not my bonds’?
  • The Fed put. The more the Fed intervenes when troubles arise, the more investors get reassured that the Fed will also come to the rescue next time around. When the Fed saves markets, it is sometimes called the Fed exercises the “Fed Put”. The potential problem here is that if investors believe that the Fed will exercise the Fed put, investors will be tempted to take on even more risk. Those of us concerned about systemic risks get nervous.

So, in the end, the announcement of the PMCCF and SMCCFs was crucial during this crisis. There are, however, important dilemmas that need to be addressed when evaluating whether such programs should be part of the standard toolbox. I am not saying they should not. I am saying that one needs to be careful.

Conclusion

The Fed launched massive “traditional” interventions in late-February/early March, lowering the Fed Funds Rate and buying mortgage and government bonds. In spite of these very large interventions, equity and credit markets kept on tail spinning. When firms struggle, it hurts economic activity and employment. The Fed got nervous.

The Fed announced – and this is the whole point here; they only announced – that they would start buying corporate bonds. Markets turned upside down. Credit markets stabilized, credit spreads narrowed, corporate bond-market liquidity improved, and stock markets cheered. And, all these things without the Fed spending a single dime until several months after the fact. Even today, the Fed has spent very little (some might say that USD 12bn is a lot, but compared to asset purchases of USD 3,000bn, it pales).

It was a “Whatever it takes” moment. It illustrates how managing investor expectations can be crucial. Understanding this announcement is thus important for understanding the behavior of financial markets during this pandemic.

The weird stock market. Part II: Potential explanations

The behavior of the stock market during this recession raises three main questions: (i) why did stock markets fall so spectacularly during February/March, (ii) why did stocks rebound so spectacularly during April/May, and (iii) why is the stock market currently at its pre-crisis level? My previous post (link) presented the stylized facts and addressed stories that cannot explain the facts. In this post, I provide some potential explanations.

I my previous post (link), I mentioned that the rebound in the stock market since its low in March cannot be explained by (i) revisions to the economic outlook – in fact, economic forecasts were revised down during spring, (ii) a preference for just a few (FAANG) stocks, as the rebound has been international and broad based, even when large-cap stocks have done particularly well, (iii) a hypothesis that this recession is not particularly bad – in fact, at least in the short run, this recession is much worse than the 2008 recession, or (iv) the fact that markets also recovered after 2008 – markets always recover, i.e. this is not an explanation.

What can explain it, then? First, a warning: I do not want to raise expectations too much (sorry). I will not be able to offer a full explanation of these puzzles in an app. 1,900 words blog post. Also, as you will see, puzzles remain, even if we can explain some things. Finally, I have not seen a good explanation of these puzzling stylized facts (though Gavyn Davies’ piece in the FT is a good place to continue after reading this post; link). Hence, it would not be serious nor academic if I claimed that I could explain everything. What I can do, though, is to provide some hints at what might be relevant parts of an explanation.

Explanations that contain elements of truth

Earnings suffered more in 2008               

In the end, earnings and not economic activity (GDP) determine stock prices. In the long run, there is a strong relation between earnings and economic activity, which is why we focus on economic developments when we try to understand stock markets. The relation is not one-to-one, though, in particular in the short run. Hence, let us discuss earnings.

Earnings suffered dramatically in 2008. Often, we look at 12-month earnings, as quarterly earnings are volatile. 12-month reported earnings per share for the S&P500 came in at 6.86 in Q1 2009, which is app. 10% of 12-month reported earnings in Q1 2008. I.e., earnings fell by a mind-blowing 90% during the financial crisis of 2008.

Earnings fell in Q1 2020, too, but much less: From USD 139 per share in Q4 2019 to USD 116 (12 month reported earnings), i.e. by 17%. At the time of writing, around 90% of companies in the S&P500 have reported earnings for Q2 2020. Earnings (12-month reported) seem to be coming in at close to USD 96 per share, which is a drop of 17%, too, compared with Q1. Earnings have thus dropped by 17% during each of two consecutive quarters. But, and this is the main thing, these drops pale in comparison with autumn 2008. In autumn 2008, earnings dropped by 68% from Q3 to Q4 and then again by 54% from Q4 2008 to Q1 2009. This figure shows the quarterly percentage changes in 12-month reported earnings of the S&P500 in 2008 versus 2020. “0” on the x-axis is Q2 2020, respectively Q4 2008. The drop in earnings was just so much larger in 2008.

Quarterly changes in 12-month reported earnings per share, S&P500. “0” is Q2 2020, respectively Q4 2008. For Q3, 2020 and forward, these are expected earnings.
Source: https://www.spglobal.com

“1” on the x-axis in the figure is thus Q1 2009 and Q3 2020, i.e. firms’ expected earnings in Q3 2020 (and actual earnings in Q1 2009). If these expectations hold true, earnings are expected to do relatively fine going forward.

Earnings do fall from Q1 to Q2 this year. Earnings surprises matter, too, though, i.e. whether actual earnings are higher (or lower) than expected. At the time of writing, around 80% of companies have reported positive earnings surprises for Q2. This, that actual Q2 2020 earnings are better than expected, helps explaining why stock prices rise currently.

If investors primarily look at earnings, this helps explaining why stock prices fell considerably more in 2008 than they have done during this recession and why the stock-market recovery took longer in 2008. Earnings have simply not suffered so much this time around. For that reason, stock prices have not suffered so much this time around either.

Monetary and fiscal policies have been aggressive

Another factor that helps explaining why stock prices today are at pre-crisis levels, in spite of the severity of the recession, is that policy interventions have been aggressive. Immediately, at the onset of the crisis, monetary policy turned very expansionary. This can be illustrated by the weekly changes in the Fed balance sheet, as in this graph:

Weekly changes in the Fed balance sheet. USD mio.
Data source: Fed St. Louis Database

The figure plots the weekly changes in the Fed balance sheet due to purchases of financial assets, in millions of USD. The Fed balance sheet changes when the Fed buys/sells financial assets. During March this year, there were weeks when the Fed intervened to the tune of USD 600bn. This is an enormous amount of money. It is, by way of comparison, more than twice the weekly amounts spent during the financial crisis of 2008, the figure also shows.

At the same time, yields are very low. This forces investors to buy risky assets if they want some kind of return, supporting stocks.

In addition to very aggressive monetary policy, fiscal policy has also been very aggressive.

Why did stock prices fall during February/March?

OK, so earnings have not fallen as much as in 2008, earnings for Q2 2020 have surprised positively, monetary and fiscal policies have been very aggressive, central banks pump liquidity into the system, and interest rates are very low, implying that investors need to invest their money in risky assets if they want a positive expected return. These features help explaining why stock prices today are not much lower than in the beginning of the year. But, if this is the story, why did stock markets drop so dramatically in March?

Changes to expectations to earnings

Earnings have dropped in Q1 and Q2, even if considerably less than in 2008. Perhaps the stock-price drop in February/March was simply due to a downward revision in expected earnings. Alas, this is not the case. Landier & Thesmar (link) have an interesting analysis where they look at analysts’ expectations to the earnings of S&P500 companies during Q1 and Q2 2020. They find that analysts cut their expectations to earnings of S&P500 firms, but not so much that it can account for the drop in stock prices during February/March. In other words, the drop in stock prices in February/March cannot be explained by analysts reducing their earnings forecasts.

If the drop in expected earnings cannot account for the drop in stock prices in February/March, what happened then? Financial economists have a straightforward way of explaining this. Stock prices are discounted cash-flows. To understand stock price movements, we must understand cash-flow and discount rate movements. When the fall in expected earnings is not large enough to account for the drop in stock prices, discount rates must have increased in February/March. In other words, during February/March investors required a higher expected return if they should invest in stocks. This is also the conclusion in Landier & Thesmar and in Gormsen & Koijen (link). Basically, this is the conclusion in most empirical asset-pricing literature: stock prices move too much to be justified by movements in cash-flows. Discount rate variation is the reason, the literature concludes.

When stock prices move, and it cannot be because of cash-flow movements, it must be discount-rate movements. This is fine, but it is also somewhat tautological: If A = B + C, and A moves but B does not, then it must be because C moves.  A more difficult question is what makes discount rates move in the first place? I.e., what is the deeper economic explanation? Perhaps/probably risk aversion spiked, when investors in February suddenly realized the severity of the virus. Perhaps/probably some market participants faced funding constraints. And so on. In other words, I agree that discount rates most likely spiked during March, but I am not 100% sure why and I do not know if the increase in risk aversion is large enough to account for the increase in discount rates, and thus account for the drop in stock prices.

Lingering doubts

So, a potential reason why stock markets have done better than in 2008 is that earnings have not suffered as much as in 2008 and central banks have flooded the market with liquidity (and yields are at zero). The reason why we saw a massive fall in stock prices in February/March, and an unprecedented rebound during April/May/June, then probably is that discount rates increased during the early phase of the crisis, and then stabilized. This is a story that somehow makes sense.

Two things are still strange (to me at least), though.

First, if stock prices are at their right levels now, why did they have to fall so much in March? OK, because risk aversion increased and funding conditions tightened. But, if risk aversion increased in February because investors understood that a recession was looming, why would investors turn less risk averse three weeks later, when economic forecasts just kept on deteriorating? Probably the Fed and the Treasury (via monetary policy and fiscal policy) eliminated the spike in risk aversion via aggressive policy interventions, but it is still not 100% clear how to reconcile these features of the data.

Second, the behavior of earnings has been surprising. During recessions, earnings normally contract much more than economic activity. So, when economic activity in 2020 contracts much more than in, as an example, 2008, a reasonable hypothesis is that earnings in 2020 would contract much more than in 2008. This has not happened.

To some extent, this graph summarizes both the explanation of the relatively mild response of the stock market to this recession and the remaining puzzle:

Percentage changes in US real GDP and earnings of S^P 500 firms from Q3 to Q4 2008 and from Q1 to Q2 2020.

The figure shows how earnings dropped 68% from Q3 to Q4 2008 but seems to drop only 17% from Q1 to Q2 this year. This explains why the stock market has performed considerably better during this recession compared to its performance in 2008, for instance. On the other hand, the figure also shows that GDP dropped by 10% from Q1 to Q2 this year and only by 2% from Q3 to Q4 2008, i.e. the fall in economic activity is five times larger during this recession. It is puzzling that earnings drop so much less during this recession when economic activity contracts so much more.

So, the relatively modest contraction in earnings helps explaining the relatively fine performance of the stock market during this recession, but it is difficult to understand why earnings have behaved reasonably well. Perhaps this is because banks were suffering in 2008, but are able to help firms getting through this recession. Perhaps it is because firms have been able to adapt better this time. We do not really know. From an academic asset-pricing perspective, it is interesting that the stock market has behaved so differently this time around, compared to how it normally behaves. From an investor perspective, we can only hope that the stock market will keep on behaving in a different way than it usually does, as, otherwise, stock prices will fall going forward.

Conclusion

The facts that earnings have done better than in 2008 and that monetary policy has been very aggressive help us understand why the stock market has done well during this recession. Some puzzles still remain, though. For instance, why have earnings done so reasonably well, given the severity of the recession, and why did risk aversion increase so dramatically in February only to normalize few weeks later, in spite of the worsening recession. Perhaps the sensible answer is that this recession has been unusual in many dimensions, and some things will remain difficult to understand.