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The great divide - Economists versus the markets

2016-01-21 09:32:36

Jan 19th 2016, 9:59 by Buttonwood

TWO groups seem to be staring at each other in mutual incomprehension at the

moment; investors and economists. Judging by the behaviour of stockmarkets so

far this year, the former are very worried about the global outlook. But the

latter think investors are panicking for no good reason.

Market movements (and much commentary) suggest that the big concerns are the

Chinese economy (and its effect on global output), and the possibility that the

Federal Reserve might have tightened monetary policy too soon, given the recent

weakish figures on the American economy. But economists believe that China,

whole slowing, is hardly collapsing and that falling oil prices are generally a

positive, rather than a negative, sign.

Take Olivier Blanchard, the former IMF chief economist who just published his

first blog for the Peterson Institute. Having examined the Chinese and US

economic outlooks, he thinks it is hard to justify the market movements. So

what explains the market movements? (http://blogs.piie.com/realtime/?p=5341) He

concludes that

to a large extent, herding is at play. If other investors sell, it must be

because they know something you do not know. Thus, you should sell, and you do,

and so down go stock prices.

In a note to clients, entitled Let s analyse our fears , Torsten Slok of

Deutsche Bank puts markets on the analyst s couch before concluding that

The bottom line is that I see the recent turbulence out of China as temporary

issues related to liberalizing their economy and not driven by a hard landing

scenario playing out. And even if there is a harder landing in China I struggle

to quantify the transmission channels to the US.

The fears I discuss with clients are temporary and will go away once we have

the worst behind us in terms of oil price declines and dollar appreciation.

Writing in Prospect magazine, George Magnus, a shrewd veteran observer, is less

upbeat than that but still concludes

even if the equity markets are in a bad mood, that doesn t mean we have to

conflate this with another imminent global recession. The most likely outcome,

assuming that there is no rout in equity markets, is that we will muddle

through a period of economic weakness.

Economists tend to be a bit sniffy about the prescience of markets. "Wall

Street indexes predicted nine of the last five recessions" quipped Paul

Samuelson, this from a man whose textbook regularly forecast that the Soviet

Union's economy would outstrip that of the US. It is certainly true that

markets can get ahead of themselves, on both the up- and the downside. However,

despite their disdain, economists do use markets as a predictive tool; the

Conference Board's leading indicator incorporates two measures - the S&P 500

indicator and the spread between long and short interest rates.

Using these measures is understandable. A huge fall in equity markets will dent

consumer confidence (although not as much as a fall in house prices, of which

there is no sign). A flattening or inverting yield curve (long rates below

short rates) is often a sign of a recession (largely because central banks are

pushing up rates to head off inflation.)

So should we believe the markets or the economists? Writing in the FT last

week, Larry Summers pointed out that

markets understood the gravity of the 2008 crisis well before the Federal

Reserve

and worried that

It is especially ominous when markets fail to rally on what should be good news

As a colleague pointed out, it is tempting to believe the markets only when

they are sending a message that coincides with your pre-existing views. So

having been warning for a while about the sighs of a global slowdown (look at

the sluggish growth of global trade, nothing to do with financial markets), I

am inclined to think the markets are onto something.

The big problem, however, is that market signals are not what they used to be.

Central banks are still buyers, or huge owners, of government bonds; are yields

really a measure of investor sentiment? Very low, or negative, interest rates

dissuade investors from holding cash and encourage them to buy risky assets; so

are equity prices and corporate bond yields a "true" measure? Given that the

Fed took the first step in withdrawing the stimulus last month, are market

movements an indicator of economic activity or a sign that investors are

worried that Daddy is about to cut off their allowance?