For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Do we have cause and effect all wrong, maybe markets now drive economies?
The conventional wisdom is that share prices reflect the market’s assessment of companies’ future prospects and, in aggregate, the overall market reflects the prospects for the overall economy. In this week’s note, we challenge this received wisdom.
Most investment and capital markets theory was developed decades ago and has been adapted over time. In the last 50 years, and particularly the last 20 years, the nature and structure of financial markets has changed immensely. The decoupling of currencies from gold meant money itself no longer had a real tangible value, all money and consequently all financial assets, became someone else’s liability. In the post QE markets, even the quantum of money has become unknowable and the domain of policy makers.
The world we live in today is very different from the one I was taught about when I was learning capital markets theory in the 1980s. That world was one where investors were carefully assessing the returns on a project against a supposed risk-free rate and applying a risk premium. This is what was meant to drive stock prices and therefore stock markets. It is this theory on which the concept of assets being correlated rests. Yet the very same investors who hold this to be true are happy to assume that the past two decades of negative equity and bond correlations doesn’t negate their assumptions.
The fact is the world is no longer driven in the way theory suggests, if it ever was. In a fiat money world, short term interest rates are a policy tool, supposedly to control economic activity to create full employment and sustainable inflation. In a post QE world, the whole government bond market has become a policy tool to drive capital allocation and finance government deficits, whilst maintaining stability in the banking system. So much for the bond vigilantes: central banks can simply fund the entire government borrowing needs and create the desired shape of the yield curve directly. Free markets are a thing of the past.
Against this background where does the equity market fit in? In my view it is now also a policy tool. Both recent Presidents, Biden and Trump, referenced all time market highs as signs of their success. Business confidence may be as much driven by share prices as driving them. Certainly, finance directors take a weak share price or bond spreads widening as a signal to tighten corporate belts. Consumer confidence is arguably the same, particularly with the US having such a high participation of retail investors in the stock market.
Indeed, the youngest cohort (under 35 years) has the fastest growth in net worth in the US. The boomers may complain about the Mag 7 while the youngest cohorts are fully invested. This growing wealth must surely be helping drive consumer spending and confidence overall.
Markets have for a long time understood how wealth effects from housing and stock markets can drive consumption, more recently they have talked about a Fed put. The idea is that the Fed will prevent excessively weak stock markets with massive liquidity injections. Some say this is to prevent instability in this highly leveraged era, others to simply underwrite the net worth of the ultra-rich. I would argue we have gone beyond either of these hypotheses and that the Fed is now using market levels as a policy tool to drive overall economy.
There are a few consequences of this change. One is all previous assumptions need to be put aside and we need in the first instance to consider the degree to which policy makers want to run an expansionary policy in the near term. In the long term we need to think about the potential inflationary impacts of what has clearly become a much more planned economy than we have seen for many years.
As a result, we would not underestimate the potential for markets to go higher, particularly as large US equities are subject to a continuous bid from share buybacks and cash contributions from pension contributions into ETFs. This is in addition to liquidity injections from the Fed. Long term of course we need to worry about capital misallocation as a consequence of excessive government intervention but that, at least at present, appears to be a worry for another day.
