By John Plassard, senior investment specialist at Mirabaud Group
The Dax at an all-time high as economic indicators plummet. The Nikkei at a 34-year high as Japan slips into recession. The MSCI Argentina index close to record highs as protests mount and the country is still not out of the (economic) woods. Investors are wondering why so many markets are at all-time highs despite sluggish or negative economic growth. How can such a phenomenon be explained?
The facts
Frankfurt’s DAX 40 index returned to its all-time high at the end of December 2023, while manufacturing orders fell by 3.7% month-on-month, well below the 0.25% drop expected by consensus. The construction Purchasing Managers’ Index (PMI) stood at 36.2 in November, compared with 38.3 in October, in clear contraction territory.
For its part, the Nikkei finally hit a fresh record after 34 years of waiting as the Japanese economy unexpectedly contracted by an annualised 0.4% in the fourth quarter of 2023, following a 3.3% fall in the previous period. This is the first recession in five years, against a backdrop of soaring inflation and an uncertain global economic outlook.
Private consumption continued to fall, while the decline in business spending accelerated and public spending was weak.
There are many examples of such a decorrelation between a country’s index and its growth. Now we need to understand why.
Why are indices rising while the economy is falling?
The fact that stock market indices are rising despite the slowdown in economic growth can be attributed to a number of specific factors.
- Expectations: The stock market is often forward-looking, which means that investors may anticipate a future economic recovery and price shares accordingly. Even if current growth slows, if investors believe that companies will be profitable in the future, they may continue to buy shares, driving up prices. The same applies to interest rates: they are “high” today, but expectations of rate cuts in 2024 are extremely high.
- More internationally oriented companies: It is difficult to say today that the Dax’s performance reflects the country’s economic growth. This is because most of the companies making up the index are German, but international. The Dax shows a slightly higher correlation with global economic growth than with German growth. The percentage of foreign sales of DAX companies varies from company to company. On average, more than 70% of the sales of DAX companies come from abroad. This means that German companies are heavily dependent on foreign markets for their growth and profits.
- Focus on specific sectors: Stock market indices can be influenced by the good performance of certain sectors. Even if the global economy is slowing down, certain sectors such as technology or health can be flourishing and support the index. Did you know, for example, that the Danish index (OMX Copenhagen) is up almost 16% since the start of the year? This is obviously due to the rise in Novo Nordisk shares (which account for more than 50% of the index’s weighting!).
- Short-term market optimism: Market sentiment can be fickle, and positive news or events in the short term can temporarily boost share prices, even if the outlook for growth is not brilliant. Recently, for example, we have seen some surveys of investor and business sentiment in Europe produce some quite surprising rebounds.
- Share buybacks: Companies sometimes buy back their own shares, which can artificially increase their price by reducing the number of shares available. It’s historically been an American phenomenon, but many European companies are now following suit. Takeover announcements have increased recently in Europe, particularly in the financial and energy sectors, which were the most profitable for shareholders last year. As banks continue to reap the benefits of higher borrowing costs, share buyback programmes by Unicredit SpA, Intesa Sanpaolo SpA, Deutsche Bank AG and Banco Bilbao Vizcaya Argentaria SA are pushing shares higher. A Goldman Sachs Group Inc. basket of high-yield buyback stocks has risen twice as much over the past 12 months as the 5.9% return of the Stoxx Europe 600 index, while the Solactive European Buyback index has also jumped 10% over the same period.
- A weaker currency: A weaker currency is generally seen as positive for several key reasons. Firstly, when a currency weakens, exports become cheaper for foreign buyers. This can lead to increased sales and profits for domestic companies, boosting their share prices. Secondly, many companies have subsidiaries abroad that earn money in foreign currency. A weaker currency translates into more foreign currency when these profits are repatriated to the country, which further inflates the profits of these companies and can lead to higher share prices. Finally, a weaker currency can make shares more attractive to foreign investors. Since foreign investment often boosts demand for shares, this can push up the index. The Nikkei is a perfect example of this.
Conclusion
Contrary to popular belief, there are often periods of disconnection between the real economy and stock market indices. We know, for example, that even when the economy slows down, some companies can still post strong earnings growth, which can push up their share prices. Another reason is that stock markets (rightly or wrongly) anticipate economic and monetary growth six or nine months ahead, which can be unsettling for investors. Finally, it should be remembered that indices are not an exact science, and that the only way to “see more clearly” is to invest with a medium-term horizon…
