Financial markets and the real economy: the link

by George Hatjoullis

In the mind of the many there is a one-to-one correspondence between financial markets and the real economy. There is not. In part this misunderstanding arises because this link is written about by people who have limited direct experience of financial markets. Those that do have direct experience tend not to write about the link, even if they are capable. The reason is that financial markets are best ‘traded’ as self-contained realities. Allowing too much intrusion from the real world can be bad for your wealth. However, the link is of interest and at times even to professional traders. This may be such a time.

The best way to think about financial markets and the real economy is as linked by a very flexible and strong elastic. Markets can travel on expectation far ahead of the real economy. Financial markets can also lag reality under certain conditions. The elastic eventually brings the two together but when is impossible to predict. Normally, it is the markets that do most of the moving. Moreover, the snapping back and forth of the elastic band can create volatility and confusion. Any overlap may also be short-lived. At the moment financial markets have moved some way ahead of the real economy. The key question is whether the real economy will pull markets back or whether the markets will stand still and pull the real economy towards them.

The situation has arisen because of the 2008 financial crisis and the policy response. The crisis saw a massive contraction of credit which has hurt the real economy. The contraction has not yet completed. The policy response was to flood the world with liquidity which benefited financial markets. The liquidity flood is not yet over, with Japan and the eurozone offsetting any mild inclination to contraction from the US. It is this liquidity that has anchored the financial markets and made it difficult for the heavy burden of the real economy to pull markets back. It is why we saw such nervousness when the Federal Reserve of the US first introduced the ‘taper’.

The leaden weight of liquidity will most likely keep financial markets stable for a while longer and allow the real economy to slowly pull towards valuations. It would help if some of this liquidity would leak into the real economy and offset the limited credit growth. However, the conduits for such leakage are few. The most important conduit is capital expenditure by the private sector. This can take financial market liquidity into the real economy via bond and equity issuance to finance the expenditure. The key is capital expenditure.

In the meantime the financial markets and the real economy have reached a temporary stasis. Until volatility picks up, capital gain is not the driver of financial market activity. Clip coupons, collect dividends and rents. The time to act is when there is evidence that the elastic band is about to move. Impossible to anticipate and success goes to those that recognise first that the process has begun.