The real side of financial markets

Monday 5 February saw the sharpest single day decline on global equity markets in more than half a decade. As is the case with all market movements, behind them we find a complex web of economic fundamentals, liquidity and technical factors.

Starting with the fundamentals, the overall picture is positive with ample evidence of dynamic economic growth, notably receiving an additional boost from the US tax cuts. Leading indicators, moreover, suggest more good news ahead and both economists and equity analysts have been revising up their respective forecasts on economic growth and profits. The consensus opinion is now for global growth of close to 4% in 2018, with around 2% for both the euro area and France. Indeed, good news in the form of stronger US wage growth somewhat ironically proved the catalyst for the recent financial market selloff.

To understand why, we turn to liquidity conditions. The welcome news of declining unemployment and higher production output mechanically brings an economy closer to full capacity. It is at this point that inflationary pressures typically start to build and central banks, in response, tighten monetary policy. Financial markets now believe that the US Federal Reserve will deliver almost three rate hikes in 2018. As interest rates move higher, market liquidity conditions tighten and cause risk premiums to increase.

The consensus opinion is now for global growth of close to 4% in 2018, with around 2% for both the euro area and France.

Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research, Societe Generale

Higher interest rates furthermore link back to the real economy as borrowing becomes more expensive for governments, households and corporates alike. Moreover, when asset prices decline, wealth is destroyed. Indeed, much as changes in the real economy drive financial markets, so too do changes in financial markets impact the real economy.

Add to this mix the observation that various technical factors often cause financial markets movements to overshoot and undershoot fair market valuations, and it becomes easy to see how a self-fulfilling prophecy of declining markets and a deteriorating economic outlook can emerge. Here, central banks can act as a stabilising factor. Indeed, continued decline in US equity markets would have a global impact and would likely cause the US Federal Reserve to reconsider its monetary policy tightening plans. For now, however, it seems satisfied that a correction on markets was probably overdue and, as such, is part of a healthy economic recovery.

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