Reconciling Financial Markets with the Real Economy

Jan 4, 2021
  • Jeff Shen

Quantitative analysis shows why we should not mistake recent performance of equity markets for the economy as a whole. Jeff Shen reveals what quant signals say about the near-term equity market outlook.

Financial markets have experienced a strong rebound since the initial COVID shock. In countries like the US, markets are well ahead of where they started in 2020.

At the same time, we are observing a new COVID wave emerge with full force in advanced and emerging economies alike. Brazil, Mexico and India have struggled to contain the virus but Europe has not fared much better.

Seismic shifts in stock sectors

There is plenty of evidence that the COVID shock accelerated many pre-existing trends around the world. One of the most important trends for financial markets over the years has been the rise of technology and the outperformance of sectors that rely heavily in digital technologies, while other more traditional sectors like energy and materials have been lagging.

In that sense, it is remarkable to see the big divergence of performance among those sectors and industries in US equity markets since COVID started. While internet and technology sectors are up more than 50%,Oil & Gas and department stores are down more than 50%.

The persistence of this trend has driven an important increase in the weight of those strong performing industries like Software, that has gone from representing around 3% of the S&P 500 Index ten years ago to almost 10% currently. On the other hand, poor performing sectors like Oil & Gas used to represent more than 10% ten years ago, but now they are less than 3%.

The reason COVID has accelerated this trend is because companies in the outperforming sectors tend to be more flexible and adaptable to a WFH environment. The core business of many tech companies also has experienced an increase in demand from clients as virtual connectivity and related substitutes of in-person activities for online equivalents has been the norm.

The outperformance of those sectors that have gained a higher weight in traditional indices explains in part the strong recovery of equity markets in general.

Decoding markets

We should not mistake the recent performance of the equity markets as representative as the economy as a whole.

In any economy, equity markets represent a somewhat lagged version of the economic structure: companies in sectors that had strong growth either listed their business to fund growth or had its market capitalization increased. But as economies keep evolving and modernizing new companies emerge. Over the years there has been a natural progression in the global economy, from primary functions like agriculture to manufacturing and then to services and technology.

In some sense, equity markets are catching up to the composition and future direction of the economy as a whole. This is an insight that we have been implementing in our Advantage Series of funds for some time by betting with the more forward-looking sectors that are currently underrepresented in equity markets. We call this “Economic Representative Portfolio” or REP.

Our REP implementation considers a subgroup of seven industries. The weights used for the representation of the “real economy” reflects not just the profitability and output but also employment.

This construct views technology as a technique that successful firms in all sectors undertake. The largest overweights are simply the largest companies in the sectors that are under-represented in the stock market like the Consumer sector (Amazon, Walmart) and Services sector (Microsoft, Alphabet).

These firms also represent massive employers. The Consumer sector includes the largest number of people of diverse skills and background. The Service sector tends to have more skilled and educated workers. Our largest underweight are the biggest names in the over/represented categories such as Financials and Primary industries like Oil & Gas (see chart below).

Note in the chart how the market capitalization of the sectors has moved in the direction of the “real economy” since 2014, with an increase in Manufacturing, Consumer and Services and a reduction in Finance, Primary and Utilities.

Reconciling Financial Markets with the Real Economy 
Market-Cap Portfolio versus Economic Representative Portfolio

Market-Cap portfolio versus economic representative portfolio chart

Source: Bloomberg, MSCI, BlackRock, Sept 2020

From a country perspective, this same idea implies that larger weights are simply driven by the sector composition of the largest firms. The “real economy” portfolio tends to be underweight the UK, Australia and Canada mainly from the important share of banks in their stock markets while in Saudi Arabia it is explained by Primary sectors such as oil. On the other hand, the portfolio tends to be overweight Korea and Mexico due to a large representation of Consumer firms and the US given its importance in Services and Technology.

As the global economy settles in a new normal post-COVID, this trend driven by the acceleration of technological developments is likely to come back even with more force. And although the gap between real economy sectors and equity market sectors has decreased materially in the past few years there is plenty of room for this powerful trend to continue.

Jeff Shen, PhD
Jeff Shen, PhD, is Co-CIO of Active Equities and Co-Head of Systematic Active Equity (SAE) at BlackRock.
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