What can markets tell us about the economy and geopolitics?

Economists have grudgingly accepted that stock markets are a useful signpost to the economic outlook, hence their inclusion as a component of the index of leading indicators.

I say grudgingly, because the idea that the collective wisdom of investors was greater than that of individual experts didn’t appeal to Nobel Laureate Paul Samuelson who claimed that “the stock market has predicted nine of the last five recessions.”

But then few economists have predicted any recessions at all.

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When it comes to geopolitical events, markets can be equally useful. Such events prompt the question of “what it will mean for markets?” but when the consequent forecast is confounded by reality, investors are invariably accused of being short-sighted or irrational.

This, though, is the wrong question. A more useful one would be “what is the market telling us about what will happen?”

Markets have been surprisingly resilient despite the invasion of Ukraine

When Russia invaded Ukraine on Thursday, February 24th, stock markets from Asia to Europe and the UK fell sharply and the US market initially sold off by nearly 3%. At the close, though, it was up 1.5% and markets around the world rallied strongly the next day.

Nathan Rothschild had said, apocryphally, over 200 years ago: “buy on the sound of cannons, sell on the sound of trumpets”. But the market response seemed bizarre, given the likely and potential military, political and economic consequences of the invasion. Commentators struggled to explain the market reaction.

Anatole Kaletsky of Gavekal suggested that “most investors believe this war will have little or no impact on global oil and gas supplies in the months ahead” because “appeasement of Putin is what most investors now expect – and they may well prove right” so that “the war in Ukraine will prove a storm in a teacup, unless you happen to live in Ukraine, the Baltic states, Taiwan or some other country considered by Russia or China as part of their near abroad.”

When, a couple of days later, this turned out to be manifestly not the case, markets wobbled – but still held up. A new theory appeared; that equity markets were being supported by a drop in government bond yields. The yield on the US 10 year Treasury had fallen 0.3% to 1.7% but the explanation, that there was an increased risk of an economic slow-down or recession, was hardly bullish given its likely effect on corporate earnings.

Bond yields have since gone back up, but the S&P 500 is now back above its pre-invasion level, with the UK a little higher and Europe and Japan roughly flat. In spite of everything, the war does not appear to have had more than a minor impact on markets. Why?

The popular narrative of the war seems to be driven by public opinion that fears the worst, and a defeatist media. This is not a new phenomenon: some 60 years ago, the “after-myth of war” sketch in “Beyond the Fringe” contains the quip “how grateful we were to the BBC in those dark days as it daily brought us news of fresh disasters.”

The media assumption, as admitted by Nick Robinson of the BBC (who was there), was that the Russians would be in Kiev within 24 hours of invasion. As the days turned into weeks, they remained extremely reluctant to change their forecast that a Russian victory was inevitable, perhaps because most of the reporting focused on the humanitarian rather than the military angle. Yet meanwhile, the Russian invasion had become bogged down.

Markets are worth listening to

Perhaps investors collectively foresaw this – perhaps they were just reluctant to panic. It certainly is not the first time that markets have been proved right. In both the 1992 and 2015 general elections, for example, the media, supported by the opinion polls, was convinced that the Labour party was heading for victory. Equity, bond and currency markets pointed to the Conservative party being re-elected – and they were right.

More relevantly to Ukraine, the 1990 Iraqi invasion of Kuwait caused the oil price to soar and stock markets to drop around 15%. Markets started to recover three months before “Desert Storm” and reached new peaks within six months of it, never doubting the outcome or that the doubling of oil prices was anything but temporary.

The oil price trended down for the next eight years, while economies and stock markets boomed, and didn’t regain the 1990 peak until 2005.

It’s too soon to predict that the current spike in the oil price will lead to a glut and falling prices but it may. What is clear is that equity markets are not predicting a recession and that bond markets are not predicting 1970s-style inflation. A 2.7% yield on the 10-year US Treasury could go higher and there may be good reasons why investors are happy to lose money in real terms – but investors aren’t stupid.

As Abraham Lincoln famously said, you can fool all of the people some of the time, and some of the people all of the time, but you can’t fool all of the people all of the time. The longer equity and bond markets hold up, the more compelling is a more positive message than that investors are collectively being stupid. As in 1990, this could all turn out rather better than feared.

If there is one certainty arising from the war in Ukraine, it is that the world’s developed economies will accelerate their drive to reduce their dependence on fossil fuels from Russia, the Middle East and other countries corrupted by a plentiful supply. This means favouring alternative energy, nuclear energy, fracking and conventional production closer to home.

If there is a second certainty, it is that Russia will end up pumping more, not less oil and gas to pay reparations to Ukraine; to rebuild its shattered economy; and to strengthen its defences against the Chinese who surely now see Russia’s vast, resource-rich and lightly populated East as a much more tempting target than Taiwan.

When Michael Gove said (in another misquote) “we’ve had enough of experts,” he had a point. Investors should listen to markets instead.