SFU economist Lucas Herrenbrueck explains why stock prices and other assets rise in midst of pandemic recession

It's one of the most confounding aspects of the COVID-19 era.

Why have share prices of many corporations sharply increased in the midst of a historically large economic contraction?

Simon Fraser University economist Lucas Herrenbrueck thinks he has the answer.

“With physical distancing measures in place, many people are spending less on things like travelling, eating out or attending concerts and other social gatherings,” Herrenbrueck said on the SFU website. “Instead, those who are still earning a regular income are staying home and turning their attention to investments including stocks, bonds, and real estate.”

So even though the economy is in decline and unemployment is sky-high, many people are still putting money into the equity and housing markets.

“To put it simply, the pandemic has increased demand for saving instruments, including stocks and bonds, while at the same time reduced our opportunities to spend on other things," Herrenbrueck said. "This combination is contributing to higher asset prices despite poor economic conditions.”

He outlined his growth model in a 15-page paper posted on the SFU website.

"This result is not particularly dependent on how low asset dividends fall during the pandemic," Herrenbrueck noted, "it only requires that the pandemic be short (in the sense of not lasting more than a few years), and that consumption restrictions be at least as severe as restrictions on supply."

Moreover, he also issued a cautionary note about leverage.

For example, he wrote, if a company's leverage ratio rises to 10, its dividends will fall by 50 percent. That vastly exceeds the magnitude of the current economic contraction to date. (A leverage ratio looks at how much of company's capital comes from debt.)

"If the aggregate economy shrinks even more, the firm goes bankrupt so its asset value hits zero and never recovers, even after the pandemic," he stated. "Thus, if we expect the pandemic recession to be so severe as to cause widespread bankruptcies, then the increased demand for saving instruments would not necessarily be enough to save the stock market from collapse."