The Changing Role Of Stock Markets: From Market Signal To Policy Instrument

3 charts to explain what has been happening today.

First is that stock markets have been vigorously rallying across the globe. This means that OECD markets have surged but has underperformed emerging markets.


From the Economist, ``STOCKMARKETS in many countries have risen steeply in recent days, buoyed by signals from central bankers in America and Britain that their economies may now be out of recession. Retail sales and industrial production data released this week appeared to support the sunnier outlook for America, helping the Dow Jones Industrial Average to a peak for the year of 9,791 on Wednesday September 16th. On the same day the FTSE 100 reached 5,140, its highest point since the collapse of Lehman Brothers a year ago. The Nikkei is also climbing mostly upwards. However, most stockmarkets have a long way to go to regain their pre-recession levels." (emphasis added)

Next is that while stock markets have traditionally functioned as a forward indicator of the economy, they appear to have been detached from economic reality.

Despite some signs of improvements, some major economic indicators such as foreign direct investments (FDI) have deteriorated in the face of rising stock markets.


According to the Economist, ``FOREIGN direct investment has fallen sharply since the start of the financial crisis, according to the latest World Investment Report from UNCTAD. The purchase of factories, buildings and other assets by foreign firms was hardest hit in rich countries. At its recent peak in the last quarter of 2007, 80% of the world’s FDI went to developed economies, but by the first quarter of this year FDI into rich countries accounted for less than two-thirds of the total. FDI to Flows to emerging economies has held up better.Africa rose to a new record of $88 billion last year, much of it going to countries rich in natural resources. Foreign investment in China and India also surged, as companies sought footholds in resilient economies. (bold emphasis added)

The falling FDI and rising stock market prices suggest that the stock market hasn't been dispensing with its traditional role as forward indicator.

Instead, what appears to be occurring is that global governments and central bankers, especially in OECD economies, have implicitly been using the stock market as an instrument for signal channeling. [see earlier discussion in Governments Will Opt For The Inflation Route]

By tweaking up prices of equity securities, the officialdom hopes to redeem the confidence lost or the "animal spirits" during last year's crisis and stoke an investment recovery.

What we have been getting instead has been rampant speculation and massive misallocation of resources or another bubble cycle.

In short the stock market has transformed from being a market signal to a policy instrument. Hence, traditional metrics under such environment won't operate effectively.

Moreover, another message from the FDI performance is that emerging markets such China, India and Africa have been diverging from OECD economies. In short, the decoupling phenomenon clearly in motion.

Of course all these comes with a cost.

For instance, as the chart above from Bloomberg's chart of the day suggests, rising stock markets from implicit policies to revive the animal spirits translates to a heavy onus on US taxpayers.

This is the result of inflationary policies, aimed at fixing short term predicaments and which benefits certain segments of the society but is paid for dearly by the productive sectors of the economy and by society in general, through the loss of purchasing power or higher prices over the long term.

As Henry Hazlitt once wrote, ``Inflation, to sum up, is the increase in the volume of money and bank credit in relation to the volume of goods. It is harmful because it depreciates the value of the monetary unit, raises everybody's cost of living, imposes what is in effect a tax on the poorest (without exemptions) at as high a rate as the tax on the richest, wipes out the value of past savings, discourages future savings, redistributes wealth and income wantonly, encourages and rewards speculation and gambling at the expense of thrift and work, undermines confidence in the justice of a free enterprise system, and corrupts public and private morals."

Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso

``Thinking is the hardest work there is, which is probably the reason why so few engage in it."-Henry Ford

Perhaps Stephen Jen of Morgan Stanley has read our arguments and has written an article providing an academic cover for our view. He says which I quote,

``whether inflation is positive or negative for long-term economic growth depends on whether money is a substitute (a store of value) or a complement (a medium of exchange) for physical capital.

``This theoretical debate can only be settled by statistics. Here are some key statistical facts about this relationship:

``-No clear systematic relationship between inflation and long-term growth. Unlike the Phillips Curve relationship, and contrary to popular presumption, the long-term statistical relationship between inflation and growth has been rather unstable and inconsistent, over the past decades, and across countries. There were episodes of high inflation and high growth, as well as high inflation and low growth.

``-High inflation (15-30%) was often accompanied by high economic growth. When inflation rates breach 40% or so, inflation is almost always bad for growth. However, inflation of around 15% has historically not been particularly problematic for economic growth. In the 1960s, Asia and Latin America experienced high growth-high inflation phases. Per capita income growth in these countries actually accelerated when inflation rose from single-digit to double-digit levels. Further, such a state had been sustained for a long time without major disruptions. Even now, China and India’s rapid economic growth rates are accompanied by rising and high inflation, with no apparent extreme tensions in the economies.

``-Inflation reduction has output costs. Stabilisation of hyper-inflation has had no major output losses. But reducing inflation from ‘high’ to ‘moderate’ has led to costly output losses. The experience of the US under Fed Chairman Volker – with the US economy going through a recession and a period of high unemployment to bring down inflation – is particularly representative of this process.

So in effect, the impact of inflation depends on the policies of balancing the economic growth aspects relative to the risks of inflation and can be assessed only from a micro angle or from a case to case basis and not from wholesale assumptions, see figure 4.

Figure 4: ADB Change in Inflation and Output growth (in basis point)

The ADB chart exhibits the trade-offs between more inflation and less output across the region’s economies. Each country has different impacts to the problem of inflation.

Mr. Jen concludes (highlight mine), ``The role of fiat money is key in determining whether this relationship is positive or negative. For some EM economies, this relationship could be positive, justifying central banks protecting growth and allowing inflation to rise. Investors should be aware of the risk of EM central banks having a moratorium on inflation-targeting.”

As we commented last week in Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation where popular inflation indicators seem to be on the mend as declining food and oil prices across the board signifies a decline in global economic growth than from government policies, the recent substantial broad based food and energy declines abroad confirm these trends as recently posted Why Food Inflation Will Ease Over The Interim (in pictures).

Moreover, market signals combined with political pressures have been putting the lid on these pressures too. We are seeing more and more efforts from the private sector in response to market signals to increase supply as the “Adopt a Farmer” by some business and socio civic groups.

Figure 5 ADB: Updated Food and Energy Weightings in CPI basket

Remember principally it is rising food prices creating the inflation hysteria, see figure 5. The pain comes from food (46.6% of CPI) and not much from fuel (2.4%). This explains why car sales remain firm despite the rising cost of fuel contrary to popular wisdom as projected by media.

The Bangko Sentral ng Pilipinas (BSP) also holds sway on the direction of the Peso and financial markets. If the BSP manages to increase rates enough to close the real rates gap, then it is likely that the currency yield arbitrage, aside from reducing imported inflationary pressures are likely to attract foreign investors back to the market.