Since the beginning of the year, the main global stock indices have seen their prices rise, in some cases breaking historical highs and setting new ones. The exception is the Chinese market, as of May 21, 2024, with double-digit YTD returns; the S&P is up 11.68%, the DAX 11.29%, the FTSE100 8.85%, and our FTSE MIB, although not reaching historical highs, still shows a positive return of 14.38%. The reasons driving stock market fluctuations are numerous and difficult to pinpoint, but without being superficial, three main themes can be identified: company profits, inflation relative to economic growth, and liquidity. This article will not delve into the interest in artificial intelligence and companies operating in this sector.
Company profits
The Wall Street earning season has ended, with about 55% of S&P 500 companies reporting revenues above expectations; while about 80% reported earnings surprise of 8.4% higher than estimated. All thanks to a resilient American economy, a strong job market, and strong consumer demand contrasting with inflation and high interest rates. Meanwhile, earnings reports from European companies follow what was highlighted for the US market; the best performers are in the banking, healthcare, and utilities sectors, while the German automotive sector remains weak.
Inflation and economy
Company profits above estimates and other economic indicators, including the job market, have highlighted, particularly for the United States, a good state of the economy. Analysts point out that the economy is growing at a moderate pace, and therefore, the potential for a recession or soft landing is being ruled out. In addition, considering that the economy is not growing strongly enough to require the Fed to keep interest rates stable or increase them, many analysts are starting to discount a 75% probability of a cut in September. However, given the “data-driven” approach of the American Central Bank, it is not excluded that this probability may change significantly with the release of economic data in the coming months. On the other hand, the European context is delicate, with economies moving at different speeds and subject to geopolitical variables such as the Russo-Ukrainian and Middle Eastern conflicts.
Liquidity
Without oversimplifying, central banks worldwide are fighting inflation, which arose in 2021 as a result of economic support given to families and increased consumption after the easing of COVID-19 restrictions, exacerbated by the Russo-Ukrainian conflict leading to higher utility and primary product prices. Additionally, the conflict in the Middle East and terrorist actions by the Houthis have led to a bottleneck in the Bab-el-Mandeb strait, the gateway to the Suez Canal, forcing cargo ships to circumnavigate Africa, impacting supply chains and costs. In support of these reasons, central banks, particularly the Fed and the ECB, are pursuing their restrictive monetary policy, which has brought inflation down to 3.4% in the US and 2.4% in Europe. Therefore, it is natural to wonder why the stock market remains driven by liquidity despite monetary policies aimed at reducing it. In fact, if we were to observe the M2 aggregate, we would see that liquidity has not decreased at all.
It is not possible to identify a single answer, but attention can be focused on “reverse repo operations”, the aid provided by government authorities during the lockdown period, and the buybacks carried out in 2024 and anticipated in 2025.
Reverse Repo Operations
In the years leading up to the COVID-19 pandemic, the FED and the major central banks worldwide printed a significant amount of money, excess liquidity for the economy and the market; therefore, monetary funds redirected the excess quantity to their central bank through “reverse repo” operations. During the pandemic period, the amount of such operations towards the FED amounted to 2 trillion dollars. With the growth of inflation, central banks have reversed course, moving from Quantitative Easing to Quantitative Tightening, effectively draining the liquidity previously generated. Financial operators, seeing the decrease in liquidity held at the central bank, reduced the amount of “reverse repo” by pouring liquidity into the stock market. In conclusion, in 2023 the FED reduced liquidity by 920 billion dollars, against the injection of 1.5 trillion dollars into the market by monetary funds. This is the first factor that led to the increase in stock prices. During the current year, it will be necessary to observe the monetary decisions of the FED as a decrease in interest rates would decrease the short-term yields of government bonds in which monetary funds have invested. This would be a further condition to invest the remaining liquidity in the stock market.
Aid granted during the pandemic
During the pandemic, mainly in the United States but also in Europe, families and businesses benefited from aid, increasing, especially for families, their extra savings. As a result, there was the ability to support consumption and cope with the higher debt service following the rise in interest rates.
The increased consumption led to higher revenues and profits achieved by companies, which exceeded expectations.
However, according to a report issued by the Federal Reserve Bank of New York, there is an increase in defaults by American families, as the extra savings generated during the pandemic period are running out and the level of indebtedness has increased. The overall debt is at a record high and amounts to 17.69 billion dollars between mortgages, credit cards, and loans.
This indebtedness could compromise domestic demand and, consequently, the economy.
In terms of the production fabric, companies are forced to renew financing at higher rates than the original ones, compromising stability for small-medium sized ones.
Share buybacks
In summary, the repurchase of own shares aims to reduce the number of shares in circulation to benefit their value.
In contrast to the restrictive monetary policy executed by the FED, various companies listed in the S&P 500 are carrying out corporate Quantitative Easing by injecting liquidity through the repurchase of their own shares.
According to a Goldman Sachs study, it is expected that for companies included in the S&P 500 index, 943 billion dollars will be invested in buybacks in 2024 and over 1 trillion dollars in 2025. Only Apple has announced a buyback of around 110 billion dollars for 2024, followed by Alphabet with 70 billion and Meta with 50 billion dollars.
The reduction of shares in circulation has the effect of improving the E/P ratio, effectively decreasing the denominator. This operation results in a distortion of profits achieved.
Conclusions
Focusing on the situation in the United States, which can be adapted for the main developed countries and their stock indices, there is ample liquidity to invest in stock markets.
Considering the potential difficulty of American families, a possible increase could affect domestic demand. This could lead to a decrease in inflation and the subsequent decision of the FED to start cutting interest rates.
The decrease in interest rates would benefit stocks as part of the liquidity held in monetary deposits, which invest in short-term securities, could be used for different investments, including in stocks.
