Deutsche Bank: The Simplest Economic Law Explains Stock Market Rallies Around the World
Deutsche Bank chief global strategist Binky Chadha goes back to basics in an attempt to make sense of the market’s gyrations over the past 20 years.
The bursting of the tech bubble, the rally preceding the financial crisis, the housing bust, and the rebound that followed can all be linked to a principle learned in Economics 101: supply and demand.
All else equal, if supply stays the same and demand rises, you should expect prices to increase, and vice versa.
Chadha deploys what he deems to be simple measures of supply (issuance minus buybacks) and demand (flows into mutual funds and ETFs) to explain the quarterly performance of the S&P 500:
“This simple measure of the demand-supply gap is highly correlated (74%) with quarterly S&P 500 returns over the last 20 years,” he writes. “The framework attributes the current bull market to the steady shrinking of equity supply from buybacks (2.5% of market cap annually) while inflows remained limited for most of the period.”
Chadha uses slightly modified measures to apply this model to European and Japanese markets, due to data availability issues. Demand plays the predominant role in driving price action in those locales, he found.
These three major equity markets, Chadha explains, have been rallying for very different reasons:
At one end of the spectrum, the equity market recovery in the US has been almost entirely driven by shrinking supply through buybacks. Since the market bottom in Mar 2009, net buybacks have amounted to $1.8 trillion or 13% of market cap, while on the demand side inflows have cumulatively been near zero. In Europe by contrast, the rally reflects a resumption of inflows over the last 2.5 years, while supply has been rising with new equity issuance and negligible buybacks. In Japan, much like in Europe, inflows have been the primary driver, amounting to $100bn or 60% of AUM since the start of Abenomics in late 2012.
Going forward, Chadha anticipates that the pace of inflows into equities seen since 2013 will continue or accelerate as part of a rotation away from fixed income as interest rates tick higher.
Though rising rates have the potential to eat into debt-fuelled buybacks, he sees record-high share repurchases in the United States continuing to increase, with much room to grow amongst the financials.
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