Nobody who works in the financial markets, or writes about them professionally, can do so for long without recognising that their logic often seems to come straight out of Alice in Wonderland. In few other areas of everyday activity are we invited so regularly to believe that what seems “good” is in fact “bad”, and vice versa. Not surprisingly, this tends to baffle ordinary investors, and reinforces the notion that there is some mystique about finance which it is not given to mere mortals to understand.
The most common example is the day when the markets fall sharply after taking fright at some piece of economic news which to any lay observer seems to be unalloyed good news, but which is nevertheless greeted by the markets as something close to Armageddon. The next day’s headlines almost invariably refer to “market turmoil”, or some such similar phrase, and record how billions of pounds have been “wiped off” share values by falling prices.
This phenomenon, which happens more often than you would have thought possible, happened again eight days ago. Anyone who read the financial pages last weekend might be forgiven for thinking that some climactic economic disaster had befallen the world, judging by the gloom in the headlines. The pretext was the fact that Wall Street had fallen quite sharply on Friday, a drop that was widely expected to be followed by sharp falls in London and other international markets this week. Meanwhile, the bond markets, which have been weakening since January, continued their run of weakness.
And what was the cause of this sudden attack of jitters, which prompted a “markets in turmoil” front page story in the Financial Times? None other than the release of the latest monthly employment statistics in the United States. These showed that “non-farm payrolls” – as the Americans call the figure they use to count those with a job – had jumped by 705,000 in a single month. In plain English, nearly three-quarters of a million people who did not have a job the month before now do have one.
If ever there was an example of seemingly clear-cut good economic news, this surely was it. If more people were being employed, then the economy must be doing better too. And yet the news sent Wall Street tumbling by over 150 points, and investors, so we were led to believe, into something approaching panic. In the event, stock markets all round the world have fallen this week, though not by as much as many originally feared.
Bond yields have also continued to rise, pulling up medium and long-term interest rates, and quite swamping the impact of Mr Clarke’s latest trifling 0.25 per cent cut in short-term interest rates. No wonder those who follow the doings of the City and the markets from afar are bemused by these strange events. Even Sir Samuel Brittan, doyen of economic commentators, was moved in his column in the Financial Times this week to say that Karl Marx would have been proud of what had happened – since it seemed to demonstrate that the markets only prosper when labour is in retreat.
How then to pick a path through these strange and paradoxical events? And what does it tell us about where the markets may be heading now? The answer, I think, is to hang on to the following simple propositions about how markets behave, all of which have been amply borne out by events of the last few days.
1. Markets do not like to be taken by surprise. The real problem with the US employment data was not the trend it showed, but the fact that the published number was much higher than most economists had been expecting. It forced them to re-examine their assumptions about what they thought is happening to the American economy.
2. In particular, the data (assuming it is confirmed by other statistics) suggests that the US economy is growing much faster than most people realised. Last year’s worries about a “new recession” can be safely laid to rest. But growth is very much a two-edged sword for investors. What is good for company orders and profits may also be bad news in as far as it threatens to push up inflation and raise the cost of money.
3. Markets cannot live without worries of some sort. The new one is that interest rates, having fallen sharply over the course of 1995, are unlikely now to fall much further, if indeed at all. The danger now is more of the economy growing so fast that it starts to generate new inflationary pressures. This may prompt the Federal Reserve to think about raising interest rates again (even though this is an election year when such increases are unusual).
4. No market is an island any more. In these days of growing interdependence, what happens in the US economy and in US financial markets quickly spills over into the UK and the rest of Europe. The long-term trend in interest rates for the last five years has been downwards. If the interest rate cycle in the United States is about to reverse, you can be certain that the same will eventually happen over here. But bear in mind, finally, that:
5. Markets are anything but omniscient. Today’s crisis frequently turns out to be tomorrow’s false alarm. Those investors who can ignore the daily dramas and concentrate on the long-term trends will always be the ones who fare best. On that score, the omens are nothing like as ominous as the headlines suggest. My reading of the historical trends is that we have still not reached the bottom of the down wave in long-term interest rates, though it cannot be all that far away.
Editor’s postscript (September 2020). My arguments have been borne out many times since this article first appeared nearly 24 years. Media headlines continue to describe an Alice in Wonderland world where good is often bad and bad is often good and nothing is every quite what it seems. However I could not have been more wrong about the last sentence. The down wave in long term interest rates is still with us nearly a quarter of a century later, for reasons that I did eventually come to appreciate a few years after this was written.