AUSTRALIA'S PLACE IN THE GLOBAL ECONOMY

Are stock markets a good projection of economic health?

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What Has Happened?

The Australian stock market has taken a plunge in light of COVID-19; the ASX200 and All Ordinaries indexes dropped by 1.32% and 1.22% respectively on the 22nd of July. On an eerily similar note, Josh Frydenberg confirmed that as per the current and predicted figures, Australia is very much on a recessional precipice.

 

Whilst the above indicates that there is at least an alignment between stock market figures and the state of the economy, the US has potentially managed to diverge from this tentative conclusion. The US economy has experienced the worst quarter since World War II as reflected in a GDP fall of 32.9%, and yet the American stock market, although turbulent, seems to be recovering to levels akin to the pre-COVID climate. In particular, the ‘MAGA’ stocks (i.e Microsoft, Apple, Google and Amazon) have surged at a pace that some are comparing to the Dotcom Bubble of 1999 and 2000.

 

Thus, a crucial question remains; are stock markets truly a good projection of economic health?

Syllabus Links

Investor Confidence

The key reason why the stock market can potentially act as a projection of economic health is centred around investor confidence. If the economy is contracting for example, confidence in Australian companies and the size of returns received from Australian stock falls, subsequently catalysing a corresponding fall in actual purchase of stock. This shifts the demand curve to the left and thus places a downward pressure on stock prices as reflected in the below figure.

Implications of negative sentiment

However, investor confidence not only has the ability to potentially allow the stock market to reflect economic health in real-time, but it can also allow the stock market to align with preempted and thus future economic conditions. Hence, if it is expected that the economy will contract, investors will accrue a similar fall in confidence and act in a manner similar to the above section before this contraction actually occurs.

Herd Mentality

However, the choices made by investors may not necessarily be informed by a commentary on the current or future state of the economy, but rather, what other investors seem to be doing. This is known as the herd mentality.  The major implication of this mentality is that once an economic trend is detected and some investors act accordingly, many others will follow suit which would shift demand in a way that extensively either drives stock prices down or up and thus exaggerates the true state of economic conditions by either making them seem either too negative or too positive respectively. The herd mentality is so impactful as there is little incentive to operate against the major sentiment of investors, especially in an environment so volatile and relatively intangible as the stock market.

Quantitative Easing

When the American stock market is explored in particular, the main reason as to why it contrasts the trends of its own economy is actually due to aggressive monetary policy being undertaken by the Federal Reserve, their central bank. The Fed is buying corporate bonds on the secondary market to promote liquidity and the availability of credit to employers. This is actually called quantitative easing, a topic that has been analysed in an earlier Echo article.  In doing so, the Fed is pumping and thus providing companies greater access to cash which prompts investors to expect stronger business revenues and profits and thus drives up investor confidence, shifts demand to the right and drives up stock prices. In short, the Fed is facilitating the process in the first syllabus dot-point.

 

When the above issues are considered in conjunction, it is clear that the question posed at the beginning of this article cannot be answered with absolute certainty; there are many factors at play with their own weightages which yield differing outcomes. However, what many economists are advising is to not only observe with a sharper eye than usual, but further, accept that these observations may be, and are likely to be, transient. In fact, by the time this article is published, much of its content involving current economic figures and conditions may not necessarily be correct due to this said transience.

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