Signals From Financial Markets

Author:Mr Ian Stewart

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...

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