Strategy & economics
It's not all about price
When you listen to the Radio 4 news headlines in the evening, the newsreader normally tells you what the stock market has done. It normally comes a long way down the list of what the BBC judges is important – but even this is an improvement on a few years ago. What the stock market has ‘done’ is normally limited to the points move in the FTSE 100. There is little other detail, and it is rare to hear the BBC acknowledge that there are any other financial assets that might be of interest.
In one respect, to be fair, the BBC is little different to those of us actively involved in financial markets. If one of my colleagues asks me what the stock market has done, I will also tend to say that the FTSE 100 was a number of points higher or lower at the close. If I have been paying attention during the day, I might note that it was higher or lower during some phases of trading, and just occasionally, I might add that business volumes were high or low.
In fact, healthy turnover volumes in all markets are vitally important. Not only do they allow us to get the business done that you might be involved in, but they are also a key characteristic of the disposition of the market. During the summer, most financial markets in the West experience a natural lull in activity. This is largely due to significant numbers of people being away. But it also reflects a hiatus in our thinking. Around the turn of the year, we are busy making investment decisions for the twelve months ahead. During the summer, it is often the case that we are still not quite sure whether those decisions were correct, and we tend to sit back and watch economic and financial events evolve for another couple of months, until we feel sure about what steps we want to take next.
Markets without turnover, as is often the case during the summer, are markets without conviction. As such, they are easy to destabilise. And markets without turnover are also subject to gravity. In other words, during periods of low trading volume, share prices will not tend to float in space, untroubled by the minor disturbances around them. Rather, even if the news environment seems fairly neutral, prices will tend to drift lower. This may be partly because there is a natural tendency for prices of any product to fall to a level at which there is some buying interest. Simultaneously, there are always people who have to sell an asset, but it is rarely the case that there are people who have to buy. Buyers always have the advantage of being able to wait. So, if most people are in a mood simply to do nothing, prices can fall to a level that is more attractive than might be seen in a higher volume environment.
It is against this backdrop that we have seen markets unnerved this summer by growing geo-political tensions. In fact, the surprise may be that markets have not reacted more, and earlier in the year, to events in the Ukraine and Middle East. It is easy to destabilise markets when there is very little momentum, particularly when there is a prevailing downwards tendency. But the greater surprise may be that what could potentially be very damaging events in Eastern Europe and elsewhere did not have greater impact when markets were more active. This could be better understood, perhaps, were there an equally strong impetus on investor sentiment from the opposite direction. But at face value, this does not appear to be the case. Yes, the global economy remains on a recovery path, but the incline is shallow and the near-term profile looks quite uncertain. While the US economy has bounced back from a weak first quarter, growth forecasts for the year as a whole have ratcheted down. Elsewhere, conditions in the Eurozone have deteriorated over recent months, and China has been stuttering. The UK produced standout growth during the first half of 2014, but it will struggle to maintain that pace over the remainder of the year – at least, not without some cost to the trade accounts.
So, I am surprised that equity markets have not shown even greater nervousness. I am also intrigued by the performance of some individual asset prices. You might, for instance, have expected gold to have been firmer over this period and it would also not have been surprising to have seen energy prices, particularly oil prices, spike higher reflecting the threat of supply disruption (and notwithstanding some question marks hanging over the performance of the global economy). But possibly this is telling us more about the longer-term supply environment than the likelihood of short-term output interruption.
More obviously and understandably, perhaps, there has been a loss of appetite for riskier assets, at least in relative terms. This has been most apparent in the contrast between the weakness of equities and the astounding strength of higher quality government bonds. But even in this relationship, there are definitely some oddities.
A couple of things can be added to the information mix that might help explain recent moves. First, there has been a notable rise in corporate M&A activity. In many cases, the rationale for takeovers has been largely defensive in terms of corporate market positioning, but it still indicates that finance directors do not believe that common equity is overvalued, and it still points to a degree of confidence in the economic future. Alongside this, perhaps the biggest underlying influence on market activity remains quantitative easing. Just because the Federal Reserve’s programme of QE is drawing to a close does not mean that its impact will immediately disappear.
There are still huge amounts of liquidity sloshing around the international financial system. Almost certainly, this has helped protect equities from displaying more pronounced nervousness over recent months, and has allowed investors to focus their attention on longer-term value. But the greater impact has been on bond markets. In my view, most bond markets, particularly at longer maturities, are heavily over-valued. This may sound like a rather-too-often-repeated statement, one that is continuing to be confounded by the reality of the market place. But asset valuations can become misaligned for long periods, just as emperors can walk around with no clothes because it suits everyone else not to point it out (particularly when it was almost equally under-clothed central bankers who encouraged the de-robing in the first place). Indeed, there is no reason why the state of undress in bond markets should not persist for some while longer – until the chill wind of inflation suggests it would be better to seek a little more protection from the elements.
This still leaves the mystery of gold. But, if there were no mysteries in financial markets, they would be very dull places.
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