Market falls a result of liquidity worries

There is no direct connection between financial markets and economic fundamentals. In retrospect, it should be clear that the stockmarket boom of the late 1990s did not represent a “new paradigm” of uninterrupted growth and technological advance. Similarly, the correction in global markets since May 11 should not be taken as a straightforward indication of economic problems.

Of course, most fund groups simply played down the significance of recent falls. Many employed their default response to such problems: arguing that they represent a buying opportunity as shares have become cheaper. But such arguments miss the significance of recent developments.

To return to the start, the relationship between financial markets and the economy is not DIRECT. Rising markets do not mean a strong economy, and falling markets do not mean a weak economy. However, that is not the same as saying that there is no relationship.

The key point is that the relationship between financial markets and economics is indirect. It works itself out in many complex ways depending on the circumstances in which it operates. In this sense, it is crucial to understand the context to assess the significance of any particular market movements.

A striking feature of the most recent market falls is how much concerns centre on liquidity. The drop seems to have been at least partly precipitated by concerns about rising interest rates. Such worries in turn relate to worries that inflation may be rising more strongly than expected. The most recent monthly Merrill Lynch fund manager survey confirms this pattern (see article).

Such concerns show that the immediate worries of investors are not centred on the real economy. Rather, markets have benefited from huge flows of liquidity, which have pushed up asset prices. However, when the upward momentum of markets is questioned – for example, by the prospect of higher interest rates – the direction of momentum can reverse.

At root, however, such huge pools of global liquidity indicate a more fundamental problem. They come about as a result of a weak dynamic within the global economy. As a result, companies often find it more profitable to play the financial markets than to reinvest productively.

Admittedly, global economic growth figures appear fairly strong at present. But these are misleading in several ways. For a start, expressing them in purchasing power parity terms, rather than market prices, gives an exaggerated importance to rapidly growing economies such as China and India. In addition, the growth of the world economy has come to depend on huge capital flows from East Asia and the Middle East to America.

Fund Strategy will return to these questions in future issues.