Mark Riggall: If the economy is going to catch a cold, why isn't the sharemarket sneezing?

Social distancing has exacted a toll on global economies but the sharemarket appears unaffected. Photo / AP

COMMENT:

Sharemarkets the world over have risen significantly since the lows on March 23. Sharemarket indices such as New Zealand's NZX50 (an index that measures the performance of some 90 per cent of New Zealand equity market capitalisation) and the US markets S&P 500 (an index that captures the performance of the 500 largest US companies) now sit close to unchanged since the beginning of the year.

Social distancing has exacted a toll on global economies but, in a climate of economic anxiety and uncertainty, the sharemarket appears unaffected.

According to Warren Buffet, in the short-term sharemarkets are a voting machine, reflecting the mass optimism and pessimism of investors. The sharemarket is presently reflecting optimism from investors the world over. Having feared financial Armageddon in March, they are now responding to economic data that suggests the impact may not be as bad as was feared.

In the developed world, the spread of Covid-19 is no longer accelerating exponentially, restrictions are being removed, and companies are reporting significant increases in activity. Government support programmes have maintained income levels for many and although unemployment is high and expected to rise, the ramifications of this have yet to hit home.

Buffet also described the sharemarket as a weighing machine in the long term, i.e. for long-term returns you need to pay attention to the value of the shares that you are investing in.

A company's share price is based on expectations of future cashflows and profits. It seems global share investors currently expect aggregate profits to be broadly unaffected by the Covid-19 crisis (or are willing to pay a higher premium for lower profits).

But it is well worth asking whether the current optimism is justified. Government support programmes can't last forever: at some point the private sector will have to stand on its own two feet. Companies tend to cut costs quickly, laying off staff when revenue falls.

The confidence to re-hire returns more slowly, so spikes in unemployment tend to persist. Unemployment reduces income, which in turn reduces consumer demand, leading to lower company revenues and profits.

For some companies, any reduction in profits generated by the pandemic will be a small blip in a long future of stable cash flows. However, the outlook for many others will have changed dramatically. More than ever, it is important to understand the fundamental drivers of the industries and businesses in which you choose to invest.

Over the next six months, we will learn more about the spread of the Covid-19 virus as lockdowns and other restrictions are eased, about progress towards a widely available vaccine, about governments' appetite to prop up economic activity, about global consumer confidence in the shadow of a pandemic, and about the willingness of companies to hire workers and chase growth opportunities.

The interplay of all these factors will affect the path of sharemarkets over this period and beyond – and we will discover if the current optimism is misplaced or bang on the money.

• Mark Riggall is a portfolio manager at Milford Asset Management