In its latest Economic Outlook, the OECD assumes that renewed virus outbreaks will remain contained and that a vaccine will be widely available towards the end of 2021. It expects real GDP in the US to grow 3.2% next year after -3.7% this year. For the euro area, growth is forecasted at 3.6% in 2021 after -7.5% in 2020. The September Interim Economic Outlook had the US growing 4.0% in 2021 (-3.8% this year) and the euro area 5.1% (-7.9% in 2020). Despite the prospect of vaccination, growth is now expected to be somewhat less robust next year compared to the September Economic Outlook, so clearly, the assumptions on other drivers of demand and activity must have changed.

Against this background, the spectacular performance of equity markets since the announcement on 9 November that a highly effective vaccine was under development, may raise eyebrows. If GDP growth next year is expected to be slightly less dynamic than anticipated in September –so before the announcement of a vaccine-, what explains the stock market rally?

One explanation would be that the rebound in company profits could be far stronger than the increase in GDP. In 2020, many companies will have operated close to their operational break-even and many others will have made a loss. When demand for their products and services increases in 2021, more companies will become profitable again and those working close to break-even this year should see a disproportionate improvement in their profits.

A second explanation is the dovish communication by central bankers. The ECB has committed to recalibrate many parts of its policy at its meeting on 10 December to take into account the economic repercussions of the second wave and the huge gap between observed inflation –which has been negative for several months in a row- and its inflation target. In the US, Jerome Powell and several of his colleagues have expressed increasing concern when describing the economic situation –there is a clear loss of momentum- and the outlook for the near term. The prospect of a monetary policy stance that should remain very accommodative for a long time forces investors to take more risk. It also gives them confidence in doing so, based on the argument that, should growth slow down, more liquidity will be injected in the system.

The third and most important reason that has supported the willingness to take risk is the change in the distribution of expected growth. Discussions about the outlook for GDP or profits mostly concern the average or median growth forecast. In reality, investors care about the entire distribution and wonder how likely it is that growth could surprise to the upside or to the downside. Often there is an imbalance between the two, with downside risks dominating. This has been the message of international organisations and central banks this year because of the pandemic. Most investors have an aversion to risk –they prefer being less exposed to potential bad outcomes even if this implies they will benefit less from good outcomes- so they will feel very uncomfortable when risks are tilted to the downside, even more so when tail risk –very extreme events- is a distinct possibility. The news flow in recent weeks about highly effective vaccines has significantly reduced the tail risk. It also implies that the imbalance of risks is less tilted to the downside.

The difficult question however is how much this reduction in uncertainty is worth in terms of stock market valuation. Answering it is extremely complex although research shows that a large fraction of the equity risk premium represents a compensation for the exposure to rare events, i.e. tail risk. This implies that the drop in vaccine-related uncertainty is worth a lot. With the imminent start of vaccination campaigns, one can expect that the market focus over the coming months will gradually shift towards the growth outlook: the question is no longer whether there will be a vaccine but when a sufficient number of people will have been vaccinated so that worries about infection risk no longer disrupt economic activity.


Reproduced with the kind authorization of L’Agefi Hebdo