UK: Signals From Financial Markets

Last Updated: 8 December 2014
Article by Ian Stewart

Most Read Contributor in UK, August 2017

The performance of financial markets provides information about where the world economy is going. Of course, as any investor knows, the signals aren't always right – just consider the exuberance around bank shares in the run up to the financial crisis.

But asset values do reflect the bets investors are making. More is at stake for investors in buying an asset than for economists in forecasting it. Both pieces of information are useful and both are fallible; but it generally takes more conviction to invest in something than to forecast it.

Here's our reading of the financial market data.

Global equity markets have recovered much of the ground they lost in September and early October in the last six weeks. The underlying economic fundamentals have not changed much, but perceptions of geopolitical and financial risk have eased.

US equities have had a good year, with returns of 13%, making it one of the best performing major markets. US economic data have generally been pretty strong, pointing to acceleration in growth in 2015. In the last five years rising equity prices have been underpinned by the Federal Reserve's cheap money policies which have kept interest rates low and liquidity plentiful. Yet the Fed's decision, in October, to end its programme of Quantitative Easing (QE), has had little apparent effect on US equities.

The US market may have shrugged off the ending of QE because it believes that growth is sufficiently entrenched.

In Japan, where growth prospects are far more mixed, the announcement, in October, of a new programme of QE has had an intoxicating effect on equities. The main Japanese index, the Nikkei 225, has risen by 18% in the last 6 weeks. Since 2013 the easy money policies of Prime Minister Shinzo Abe have weakened the Yen and pushed up Japanese equities.   

Like the underlying economies, euro area equities have had a poor year, with the overall market down 4%. Greek economy equities have suffered most, falling 24% despite Greece's emergence from a six-year recession. 

Gloom about prospects for the euro area has led to a stampede by investors into the supposed safe haven of government bonds. On average euro area government bonds have returned 15% so far this year. Spain has been the top performer, with government bonds rising 25% in value.

Two forces are at work. Investors fear that inflation, which is running at just 0.4%, could fall into negative territory in the coming months. Bonds, with a fixed value and return, represent an attractive investment in a world of falling prices. (It is a measure of the degree of concern about deflation in the euro area that the interest rate on Spanish government bonds are lower now than those on US government bonds). Investors also see a growing possibility that the European Central Bank may start to buy government bonds in effort to kick start growth. Major new demand for government bonds would further bolster prices.

Interest rates, or yields, on bonds fall as bond values rises. The result of the rush into euro area government bonds has been to drive interest rates in the euro area to record lows. Governments in the major countries of the euro area have the lowest borrowing costs since records began in the eighteenth century.

Despite a strong rebound in UK growth the performance of UK equities has been lacklustre, returning 3% this year. As in the euro area, investors would have been better off holding UK government bonds, which have returned 12%, rather than equities.

The asset class which had an unambiguously bad 2014 is commodities. The oil price has tumbled, with the benchmark Brent crude falling to a four year low of just over $70 on Friday. Metal and agricultural prices have also fallen. Lower commodity prices have hit growth in commodity-producing nations including Russia and Brazil and are bolstering spending power and growth in the industrialised world.

In recent weeks there has been growing speculation that the European Central Bank may, belatedly, follow the US, Japan and the UK by embracing Quantitative Easing. If the ECB does go down this path experience elsewhere suggests that the policy would work partly by pushing up equity values. It is worth keeping an eye on the news from the ECB – and European equities – for signs as to whether Europe is taking this historic step.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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