Breakingviews - Hadas: Beware of the curse of financial markets

LONDON (Reuters Breakingviews) - Financial markets have some things in common with professional sport. Investors and fans are both desperate for winners and despondent about losing. They are passionate about little ups and downs, while outsiders often find the rules arcane and the enthusiasm weird. And for both, all the jumping and screaming has little effect on the rest of the economy.

The last claim is controversial for finance. Surely, say thousands of speculators, investors and commentators, prices in financial markets are guiding stars in the economic firmament. Sudden moves, like the 4 percent drop in the U.S. S&P 500 index last week, must mean something. Slower but larger moves, like the 27 percent decline in the Shanghai Stock Exchange Composite index since the end of January, surely have a broader significance.

But of what? Do tumbling markets anticipate falling profitability or slowing economies? Or perhaps they will somehow cause a slowdown in growth. Or maybe these particular drops in equity values are merely an adjustment to previous excesses or to higher bond yields.

And what do those yields signify? If bond market fluctuations have economic meaning, it is hardly crystal clear. The yield on the global benchmark, the 10-year U.S. Treasury bond, has risen from about 2.4 percent to 3.2 percent since the beginning of 2018. That might be a sign of a growing economy, or could cause a slowdown. It may reflect expectations of higher inflation rates, but may also discourage inflation from taking off.

As in sport, the uncertainty can be exciting. However, it does suggest that in practice financial markets are not really closely tied to the rest of the economy.

Start with the price of shares. These get many headlines, but they have very little direct influence on real economic activity. They cannot, since share prices moves do not change the amount of money available for investment. When companies want cash for expansion, they very rarely sell new shares on public markets. Most established businesses borrow or dip into operating cash flow. New companies mostly rely on private fundraising.

In theory, debt is different. Indeed, it is at the centre of the theoretical explanation of the role of financial market prices in the economy. The model starts with the overnight policy rate set by central banks. That is supposed to influence yields on longer-term obligations. All these interest rates then determine the quantity of fixed income finance, which sets the pace of investment, which finally shapes job creation and growth.

The model’s financial hydraulics are impressive but not realistic. They leave too much out. Even when there is some financial transmission, it is often drowned out by, among other things, changes in operating profitability, government policies, technological opportunities and the political situation.

Also, finance itself is subject to many more variables than official interest rates and benchmark yields. Inflation can change high nominal rates into low real ones. Regulation shapes lending practices. Borrowers’ costs depend not only on the risk-free rate but also on the spread demanded by lenders. The effect of debt on the economy depends on whether the borrowed money pays for real investments or just backs financial transactions.

With all this going on, it is no wonder that market-related chat about the economy is no more accurate than sports talk. Changes in financial markets can indeed be signs and causes of changes in the economy, but the signs are mostly unclear and inaccurate and the causes rarely crucial.

Still, financial markets these days do have one source of clout: the power - or the curse - of belief. On their own, fluctuations in financial markets may have little more direct or mechanical effect on the economy than baseball’s World Series or the soccer World Cup. The indirect psychological effects, though, can be much greater.

As long as consumers and corporate leaders overestimate the strength of the ties between asset prices and finance, they will believe that markets are aids for making decisions about spending and investment. In this way, moves in stock and bond prices can shake the economy.

Followers of financial market oracles do not think of themselves as superstitious. Rather, they think they are deciphering arcane coded messages. It is a tricky business, with a self-referential twist.

If the majority view is that last week’s stock market selloff was no more than a random gyration - one match in a long season - then it will soon be forgotten. However, if enough people believe that this particular decline is telling them something bad about future economic growth or profit trends, the gloomy prophecy could become self-fulfilling.