The Great Divergence: Real GDP Vs. Mr. Market

|
Includes: DIA, IWM, QQQ, SPY
by: Peter Newell

Summary

After years of ZIRP and now NIRP, the world is still mired in low growth and deflationary pressure.

Regardless of the real economy, American equities have continued to go higher causing a worrying divergence between the real economy and financial markets.

This divergence suggests that a correction is pending and it's not going to be as nice as the start to 2016.

The one thing we learned from the Fed this week is that the good times won't last. After the December meeting, it seemed that the majority of Fed members were bullish on the U.S. economy and were eager to normalize rates as quickly as possible, stating a good of quarterly rate hikes in 2016.

Of course we know that didn't happen and that the Fed is genuinely concerned about the effect the world economy might be having on the U.S. Despite the implications surrounding the Fed announcement, equities took off. But before you load up for the next bull-run, let's take a look at a growing divergence you might be interested in.

Low & Negative Interest Rates

First, to understand how we got to this point in history let's recap global interest rate policies:

Low interest rates are supposed to make borrowing cheaper for consumers and businesses, stimulating growth through spending and investment. The activity generated by low rates is designed to end recessions or low-growth periods, in reality much of the world never truly got out of the 2008-inspired recession. At 8 years of low growth and deflationary pressure, it might not be a dictionary "depression", but its close.

Negative rates are an even more extreme example of interest rate policy that have been introduced in Europe and Japan. Basically, they indicate that a central bank simply doesn't know what else to do to get people and businesses to spend money, so they charge them for their deposits. While it's still a new phenomenon, it doesn't seem to be making the situation better. Better yet, the European banking system seems to be on the edge of an abyss.

Global Growth & Corporate Profits

Meanwhile, global growth remains tepid despite central banks from China to Europe dropping reserve ratios and interest rates. Demand just doesn't seem to be growing enough anywhere to offset all the excess money on the market which has, in turn, been hitting corporate earnings.

Since early last year, the number of Russell 2000 (NYSEARCA:IWM) and S&P 500 (NYSEARCA:SPY) companies that have missed earnings estimates has steadily increased, despite the fact that companies and analysts reduced estimates to compensate for the market environment. More than 30% of S&P 500 and more than 50% of Russell 2000 companies missed earnings over the past 2 quarters, and the trend seems to be accelerating.

This doesn't bode all that well for the global economy, as multinationals are drivers of growth in terms of hiring and investment in emerging and developed markets.

Real Economy vs. Financial Markets

Now that we've covered interest rates and the real economy, let's talk about the divergence between the markets and economy. I believe that most of us think of financial markets as a forward-looking market, where asset prices reflect expectations about the future. As such, when the real economy looks bad, equities tank and safe havens flourish and vice versa. There should be something close to a positive correlation between the two.

Here is a chart comparing Europe's Stoxx 50 index and real GDP growth since 2012:

Click to enlarge

(Source: TradingEconomics.com)

As you can see, the equity index generally holds a positive correlation with GDP growth. But as we see now, the equity market is showing us that European investors are expecting things to get worse before they get better.

By comparison, the American markets seem to be on opiates.

Click to enlarge

(Source: TradingEconomics.com)

The Dow Jones Industrial Average is seemingly ignoring the warning signs from around the world and in our back yard as investors express all kinds of jubilation. The question is: why?

Despite years of ZIRP the U.S., the E.U. and most of the world remains mired in low-growth and deflationary pressures. Multinationals are feeling the brunt of this, lowering earnings estimates and still missing them. But still the U.S. financial markets keep chugging along fueled up on Red Bull and perennially low interest rates.

Putting off When, not What

In situations like this, when the financial markets are so dislocated from reality, it is prudent to seek refuge and hedge your long positions. The Fed announcement was bad news, they don't think the economy isn't strong enough to support higher interest rates, but still the markets jumped higher. This has been the case since the Fed introduced ZIRP after the 2008 crisis; markets have trended higher no matter what the fundamentals say.

This kind of divergence isn't promising for the future. January and February were two months that accurately represented the outlook for the global economy, and we didn't like what we saw. At some point, one of two things will happen: either American markets are going to fall hard in order to reflect the situation in the real economy or we will have to accept that Wall St. is simply an engineered concept with no basis in reality.

While there is a case for the second point, it's better to be safe than sorry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.