Peering into the entrails
Downbeat signals from the markets
Mar 22nd 2014
ARE financial markets useful indicators of how an economy is about to perform? If they are, then they are not telling an upbeat story. This year equity markets are flat-to-lower, government-bond markets are up and, as for commodities, the “wrong” raw materials are falling in price.
Economists have adopted some financial variables for their soothsaying efforts. In America, for example, the composite leading indicator uses, among other things, the change in the S&P 500 index and the spread between short- and long-term interest rates.
The theoretical link between markets and economies runs like this. When an economy expands, spare capacity starts to shrink. This puts upward pressure on wages and prices of raw materials as companies compete for resources. As inflation picks up, bond yields rise and the spread between short- and long-term rates widens. Profits rise rapidly in the first stages of recovery; the corporate sector has a high level of fixed costs, and increased demand usually leads to improved margins.
The influences on the markets change when the economy starts to overheat. The central bank gets nervous about inflation and raises interest rates. Companies suffer from lower margins as their costs rise faster than their revenues. Equity markets run out of steam. If the slowdown looks like turning into a recession, then equities and commodities fall. Government-bond markets, by contrast, gain (and yields fall) for two reasons: first, inflation is lower in a recession and, second, government bonds are perceived to be safe assets.
Given this picture, the record of the financial markets in 2013 looked pretty positive for developed economies as they headed into this year. Equity markets in the rich world did well in 2013 and government-bond yields rose. Admittedly commodity prices fell in 2013, but that was good news for Western consumers: the effect was the same as a tax cut. The picture was far less positive for those parts of the emerging world which produce commodities; indeed, emerging-economy equity markets were generally weak last year.
That weakness has continued into 2014. Several developing countries have been forced to tighten monetary policy in the face of wide current-account deficits and falling currencies. Even in the developed world, data have been disappointing: Citibank’s economic-surprise index, which compares published data with the forecast numbers, has shown its biggest decline in a year.
Industrial-metals prices, usually sensitive to the state of the global economy, have been dropping. More generally, inflation is low and deflation in the euro zone seems not too far away.
Special circumstances may explain some of this. Severe winter weather has affected America’s economy. Falling prices for metals may be the result of a crackdown on speculation in China, where copper was used as collateral for financial transactions. Metals have been weaker than other commodities, although this divergence is not necessarily good news: higher food and gas prices squeeze consumers’ wallets.
Most economists think that America will recover strongly in the second quarter, and that the Chinese slowdown will be modest. That may help explain why rich-world equity markets have not taken a bigger hit, despite the geopolitical worries over Ukraine. If the economy was really heading over the cliff, equity markets would surely have fallen more.
The importance of monetary policy should not be underestimated. It is not just that low interest rates tempt investors to move money out of cash and into equities. Low rates also appear to enhance the fundamental attraction of equities.
It is a neat trick. Barclays Capital calculates that companies have taken on more leverage: the ratio of their debt to earnings, before interest, depreciation and tax, has increased. This debt is used to buy back shares.
In America buy-backs are running at an annual rate of $400 billion, or 2.3% of GDP, according to Smithers & Co, a consultancy. Higher profits are then divided among fewer shares. The effect boosts earnings per share for the S&P 500 index by around 2%, reckons Barclays. And another familiar theme of bull markets has started to appear: takeovers. The combination of cheap borrowing costs and high share prices is ideal for merger mania, boosting the buying power of acquisitive chief executives.
All this suggests that, until the central banks start to tighten monetary policy, equity markets will be supported. High share prices are an indicator of confidence in Janet Yellen and Mario Draghi, more than in the economy itself.