Don’t drink the economic recovery Kool-Aid

It is hardly without precedent that stock markets get carried away by wishful thinking and become seriously detached from underlying economic fundamentals. Nor is it without precedent that stock markets might have failed to anticipate major negative events despite all the clues pointing in that direction. 

One such spectacular example was the stock market rally on the eve of World War I.  That rally was soon followed by a market panic and the closure of world stock markets for several months following the outbreak of hostilities that came as no surprise to non-market observers.

Today would seem to be yet another one of those occasions of irrational market exuberance with the U.S. stock market having staged an epic market rally over the past three months of some 40 percent from its mid-March 2020 lows. It has done so on the wave of easy money from the Federal Reserve and in the hope of a V-shaped economic recovery despite the many indications that such a V-shaped recovery is highly improbable. It has also done so despite the growing indications that the world coronavirus pandemic is far from under control and that the U.S. could be on the verge of a second wave of the pandemic later this fall. 

Lulled by easy Federal Reserve money, the stock market is choosing to turn a blind eye to the very uneven way in which the pandemic has affected key sectors of the economy and to the unlikelihood that the serious damage done to those sectors can be easily repaired by lower interest rates. 

One would think that so long as a vaccine is not available, no amount of easy money is going to prevent the travel, lodging, restaurant and event sectors of the economy from struggling. That, in turn, could mean that those sectors will be an important drag on the rest of the economy as an increasing number of establishments file for bankruptcy and default on their debts.

It also seems to have escaped the market’s notice that the coronavirus induced lockdown of the economy is very likely to have accelerated the trends that were already in evidence before the pandemic towards a more digitized economy and remote work. That, in turn, could add to bankruptcies and debt defaults that could have serious financial market consequences. With more people shopping online, will we really need so many shopping malls? With more people working from home, might we not have a glut of real commercial properties that will impede any recovery in construction and that will cause real estate companies to default?

More surprising yet is how markets seem to be ignoring the growing warning signals that both the U.S. and the world could be in for a second wave of the pandemic later this year. This could occur as a result of the premature easing of earlier lockdown restrictions and as a result of political demonstrations that bring many people into close proximity. It is striking that globally coronavirus cases are now increasing at their fastest rate to date while in 21 U.S. states, including California, Florida and Texas, there has been a disturbing acceleration in new cases of the virus being reported.

A second wave of the pandemic is the last thing that the fragile U.S. and global economies now need. Such an outbreak would further disrupt global supply chains on which our economy has come to depend. It could also heighten the chances that our economy and its financial markets could be subjected to yet another external shock either in the form of an emerging market economic crisis or in the form of another round of the European sovereign debt crisis.

One has to hope that while stock markets might be partying, economic policymakers are not also drinking the Kool-Aid. Rather, one must hope that they are making contingency plans now as to how to act should the economic recovery stutter or should we indeed have a second wave of the pandemic later this year. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.