Stephen King: Behind the volatility lie opportunity and fear

'We may worry that things will go wrong, but it's difficult to be precise on the nature of any problems'
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Economists often have difficulty with the simplest things. I'm not thinking about how to use a tin opener or dishwasher but, rather, how to read markets. When markets move in one direction or another, does this imply that we are moving from one world to another? Or are market moves simply a reflection of perceived opportunity or fear, whether or not these opportunities and fears are subsequently justified?

Think of some of the beliefs that economists have happily entertained in recent years. In the late 1990s, economists believed that nothing could go wrong in the US economy because the markets, heading ever upwards, told us that nothing could go wrong. This belief began to justify all sorts of wild claims. Companies such as Enron and WorldCom would surely lead us into an economic nirvana, having learnt how to harness new technologies for our collective benefit. Then, following the 2000 stock market crash, a repeat of the Great Depression was, apparently, just around the corner: what else could a total collapse in the Nasdaq stock index, the bellwether for the new economy, possibly signify?

A few years earlier economists got their knickers in a twist about inflation, largely because the US bond market collapsed in 1994. The Federal Reserve certainly raised interest rates that year and those increases didn't help bond market sentiment. But inflation? Ultimately, not a whiff. Whether because the Federal Reserve was suitably pre-emptive or because inflationary psychology just didn't exist, price pressures remained under control (left-hand chart).

We can laugh with the benefit of hindsight at some of the claims made in the late 1980s. Japan was a miracle economy where nothing could go wrong: that was surely true because the strength of the stock market, the buoyancy of the yen and the ability of land prices to defy gravity in every year since the Second World War demonstrated a faith in a Japanese economic system that had become the envy of the world.

The point about these examples is that our views of economic fundamentals become heavily distorted as we respond to market data. Economists like to believe that markets are entirely rational - in my view, a dangerous conclusion - but, even if they were, it's still more than a hop, skip and jump to providing an accurate forecast for the future.

Even rational markets are no more than a representation of the collective set of beliefs - and risks surrounding those beliefs - held by markets at any particular point in time. Because markets are moving all over the place - and economies are, generally, a lot less volatile - it must follow that the collective set of beliefs about the future changes a lot more than economies themselves do. And, as an economist's job is to tell people what is actually happening in an economy, rather than what the market is saying will happen, it's no surprise that confusion reigns when economists start to rely heavily on market data to come to a view about future economic developments.

I raise these issues because markets have, once again, become rather volatile. More specifically, after a very good run last year - bond yields lower at the end of 2003 than at the beginning, one of the biggest one- year gains in equities in the past 50 years - there is now a real sense of unease. Most equity markets are lower than they were at the beginning of the year, having more than given back earlier gains. Bond yields are generally a lot higher. And the appetite for risk has fallen away: the right-hand chart, for example, shows the spread between average emerging market bond yields and the US 10-year Treasury yield, a spread that has widened dramatically as risk aversion has taken hold.

So, if markets change their minds a lot, if one minute they're happy and the next they're sad, which of these worlds should the economist opt for? As a starting point, it is worth trying to identify why markets are going through particular mood swings. Last year, a combination of positive factors came through: growth rebounded, inflation was low, interest rates were still falling, the US and its allies appeared to have scored a victory in Iraq, US profits were rebounding strongly ... so it goes on.

This year, economic growth has continued in healthy fashion and companies are reporting strong profits. The new sense of unease is related to other factors: US interest rates are heading upwards, oil prices are dramatically higher, George Bush hasn't won the peace and the Chinese are no longer happy to be presiding over a booming economy.

We may worry about these things, but we're not always sure why we should worry. As I argued last week, the US has raised interest rates on plenty of occasions in the past, yet it is impossible to generalise the likely economic effects stemming from periods of monetary tightening. Equally, it is impossible to say definitively what the longer-term consequences of higher oil prices will be: the Federal Reserve and Bank of England tend these days to worry about the consequences for output, whereas the European Central Bank frets about inflation. And although a China slowdown would, I believe, have significant consequences for the rest of the world, there are few clues out there about the scale of any slowdown and what, ultimately, would bring it about.

What is revealed from these arguments is that markets have a right to be uncertain. Markets react to opportunity or fear. We have just shifted from a period of apparent opportunity to a period of palpable fear. The problem, however, lies in identifying not just the likely scale of any opportunity or fear but, also, its characteristics. Specifically, although we may worry that things will now go wrong, it's very difficult to be precise on the nature of any problems.

Let me suggest three scenarios. One possibility is that we are facing a re-run of the early 1970s, driven by surging oil prices. This seems unlikely. The independence of central banks suggests that an inflation psychology is unlikely to take hold. A second possibility is that we are facing another 1994: with short-term interest rates likely to head up, it is not surprising that bond investors might be feeling a little nervous. To date, the Federal Reserve has been keen to emphasise only a gradualist approach to rate increases, a rather different story from 1994. Nevertheless, I can see why markets might be fearful: the Bank of England started its monetary tightening on a gradualist philosophy but, judging by last week's Inflation Report, more aggressive monetary action may now be waiting in the wings. And, were this to happen globally, emerging market investors would surely be worried about "another Mexico".

Then there's a third possibility: 1998. Back then, markets expected rates to rise, but the central banks eventually decided to do the opposite because of a series of global financial crises - Asia first, then Russia, then the Long Term Capital Management debacle and, heading into 1999, Brazil. Fear - associated with the implications of monetary tightening - undermined the foundations for continued expansion, paving the way eventually - and paradoxically - for interest rate cuts.

Although the second and third of these scenarios are both plausible, they provide completely different conclusions about the path for interest rates. They also have very different implications for economic performance. Which is another way of saying that volatile markets are a reflection of significant underlying uncertainty - hardly surprising in a world that, according to Keynes, is partly governed by no more than "animal spirits".

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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