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Financial Markets vs. the Real Economy - Outside View by Asad Dossani

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Financial Markets vs. the Real Economy
Jan 4, 2011

The performance of the financial markets in 2010 has been positive. Stocks and commodities have gone up and investors have made good returns. The FTSE All World index (a measure of the performance of stock markets across the globe) is up over 10% this year. This is much lower than in 2009, but it still a good return.

While stocks have done well, commodities have done even better. The CRB index (a measure of the performance of commodities across the globe) is up 16% this year, another solid year for commodities. Iím sure it comes as no surprise that the one of the best performers has been gold. Gold is up 28% this year.

A simple look at the above figures would indicate that 2010 has been a prosperous year. The economic story unfortunately does not match the story in the financial markets. Economic growth in emerging economies like India and China has remained strong, but this is where the good part ends.

In the USA, growth continues to be sluggish, unemployment remains high, and the housing market is showing little signs of recovery. Europe has been struggling with a debt crisis that has made many investors question the future of the common currency. Around the world, investors continue to remain nervous about global economic prospects. There have been plenty of conflicting signals indicating that economic prosperity in the near term is highly uncertain.

Why has there been such a large disconnect between the performance of the financial markets and the state of the economy? Some of the biggest players in the financial markets are central banks. Over the course of the year, central banks across the world have been active in attempting to stimulate their economies through low interest rates, quantitative easing, and interventions in currency markets.

The financial markets and the real economy have a significant lag in their response times. Financial markets respond very quickly, whereas the economy takes much longer. So while central bank policies have had positive effects on the financial markets, they are yet to be felt in the economy. A good example is quantitative easing by the US Federal Reserve.

The purpose of QE is to lower long-term interest rates to increase mortgage lending and revive the housing market. The financial market response to QE has been a rise in stock prices and a rise in commodity prices (particularly gold). While the financial markets have responded to QE very quickly, the housing market has not yet benefitted (and there is no guarantee it will benefit at all).

Ultimately financial markets will be a true reflection of the real economy. So if economies donít end up recovering, stock prices and commodity prices will both come down to reflect this. However if 2011 proves to be a good year for economic growth, stock prices and commodity prices will remain high and see strong growth. Financial markets are in a sense forward looking. They move before the economy does, and often donít accurately reflect what is truly going on.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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