Financial volatility matters less than we're told

Stock markets have been up and down like Santa in the world's chimneys this Christmas.

After taking a record unfestive pummelling on 24 December, American shares experienced a record oneday gain on Boxing Day. It's a fitting way to end a year that has been characterised by an unusual level of financial volatility.

The MSCI World Index covers most of the developed world's largest listed companies. It raced up in January to a record high. But since then the index has shed around a fifth of that value.

And consider some of the constituents of such indexes. Apple crossed the $1 trillion (£790bn) valuation threshold in August, becoming the first listed company ever to do so. But four months on and the iPhonemaker is worth "just" $740bn. On 26 July Facebook's shares dropped by 20 per cent. That translated into a paper loss of $120bn - the worst day of value destruction suffered by a single company in US corporate history.

The global oil price has bounced around wildly too this year. In October it hit a four-year high of $86 a barrel, prompting concerns about a potential surge of global inflation. But now, within a few months, the black stuff is back down to $54 a barrel.

Sterling peaked at $1.43 in April, up from $1.34 in January. Now the pound languishes at a measly $1.26, beaten down by fears of a no-deal Brexit.

An honorary mention is due to bitcoin. The original cryptocurrency shot up at the start of the year to $17,500. Now one unit trades for only $3,600.

Why does this kind of financial volatility - these surges and slumps in prices - matter? Perhaps it seems obvious. If you own something and it halves in value that's likely to be alarming, not to mention expensive. If you're going abroad on holiday you obviously don't relish discovering that the value of the currency in which you are paid has fallen by a tenth.

Perhaps it might even be ruinous if you were planning on selling a financial asset to realise the cash for something important such as paying off a debt that's falling due. Those who have borrowed in dollars and invested in bitcoin are unlikely to have had an enjoyable year. If you were planning to retire in 2019 and your pension has collapsed in value over the past 12 months you can also see the problem.

But all these examples assume the investor needs to realise the cash imminently. If you're saving for retirement several decades hence, even a 5 per cent daily swing, like the one we saw in US stocks on Boxing Day, is really neither here nor there.

What about the real economy? It's true that financial volatility can damage a normal business, perhaps even ruin it. Think of a goods importer that sees its import costs go up due to a currency slide. Think of a small oil driller that watches the value of the black stuff suddenly plummet. When those companies expire their workers can lose their jobs and livelihoods.

But it's necessary to separate out the micro from the macro. At an economy-wide level, idiosyncratic shocks will tend to balance out in the medium term. Sharply lower energy prices are bad for energy producers but good for energy consumers. A cheaper currency can be bad for importers but can be beneficial to exporters. A currency plunge certainly harms living standards by pushing up inflation. But the impact of a revaluation on prices is temporary if it's a one-off, as we've seen since the Brexit vote.

Some economists, such as Roger Farmer, think stock market crashes lead to domestic recessions. But the causality of that relationship is disputed. And as the Nobel economics laureate Paul Samuelson caustically observed, "The stock market has predicted nine of the past five recessions."

It would be fatuous to argue that financial market volatility doesn't matter at all for ordinary people. Yet it matters rather less than we're sometimes led to believe by the noise of excited speculators and the dramatic media headlines. Sometimes it's better not to pay too much attention to the puffs of smoke emitted by the chimney of markets.

The stock market is not the economy

Live by the stock market boast, perish by the stock market boast. "The stock market has smashed one record after another, gaining $8 trillion in value," Donald Trump bragged in his State of the Union address only last week. "That is great news for Americans' retirement, pension and college savings accounts."

And now, with the US stock market down more than 6 per cent in just two days of trading? With around $1.6 trillion (£1.1 trillion) wiped off the value of US companies since Friday? What does that mean for the savings of ordinary Americans? What does that say about the economic prowess of the President of the United States who has presided over the drop? Where are the tweets from the braggart-in-chief?

Nemesis has followed hubris for Trump, at least when it comes to the stock market. And how richly deserved it is. Yet this is, sadly, no morality play. Trump's learning curve is our world. And it's not just in the US were stock markets are sharply down. Some $4 trillion has been shed from equity markets around the world in the past week. So what do these market sell-offs mean for the global economy? What do they mean for all of us? 

The first thing to do is to appreciate something that was apparently beyond Trump: that the stock market is not the economy. Stock markets can boom when GDP is stagnant, when wages are flat, when living standards are going nowhere. And they can fall when economies are picking up speed and life, for many people, is getting better. The latter actually describes the current situation.

Indeed, one popular explanation for the sharp sell-offs in equity markets in recent days among analysts is that it is actually a response to the strength of the US and global economy. There was a tentative sign last week that US average wages, after more than a decade of weakness, might finally be creeping back up to the rates of growth seen before the global financial crisis and the great recession.

The implication of that, so the logic goes, is that the US central bank, the Federal Reserve, will have to put up interest rates faster in order to stop the domestic economy overheating and inflation getting out of hand. Lower interest rates automatically boost the prices of financial assets, including stocks and shares, so higher interests should have the opposite impact. So what we are witnessing is a natural correction. And because the US economy is still the world's largest and because the US dollar is the global economy's "reserve" currency what happens there is impacting on financial markets everywhere.

Perhaps. Another explanation is that US financial markets, and to some extent those of the rest of the world, have been in the grip of irrational euphoria for some time. One often-cited gauge of the value of US markets, which compares large companies' earnings to their stock price, suggests they are more overvalued than at any time except before the turn-of-the-millennium internet stock slump and the Wall Street Crash of 1929. Another much-watched general market volatility index is spiking too.

That could suggest what we are seeing is not so much a natural, short-term, correction, but the bursting of a bubble. In other words, there could be much more to come.

So which is it? The answer is that it's impossible to say with any confidence. And the people who claim they know with certainty really don't. What we can say is that even if a stock market bubble is in the process of popping, that does not imply that the real economy - whether in the US, the UK or anywhere else - is set to implode too. It does not necessarily mean we are heading into another recession, where companies go bankrupt and people lose their jobs.

Equity markets have slumped before without causing a recession, most obviously after the internet bubble burst in 2000. The FTSE 100 fell more than 50 per cent in the following years, but there was no recession in the UK.

More recently, the Chinese stock market in 2015 dropped more than 40 per cent in months but its domestic economy was largely unruffled. In 1987 US stock markets plunged by more than 20 per cent in a single day - Black Monday - but there was no discernible impact on the real economy. The large stock market drops in 2008-09 coincided with the global financial crisis, but they were not the cause of the crisis itself. Responsibility for that genuine economic disaster lay with the fragility of the global banking system.

Equity markets do matter for ordinary people. But they matter in entirely different ways than Trump thinks and many commentators imply. The performance of the companies in an index matters for ordinary people over the long term. That's because the stock of companies is a repository for peoples' savings. And most people are not saving for tomorrow, or next week, but for decades in the future.

Public markets also matter because large listed firms in most countries tend to be major employers, significant sources of private investment and productivity-enhancing innovation. It's important that they the companies in them are subject to sensible regulation, feel competitive market pressures, that they have good corporate governance, that they invest for the future and the right financial incentives act on their managers. All those factors should concern us deeply.

But the short-term ups and downs in stock prices are largely meaningless - except, of course, if you're a speculator or a monumentally hubristic politician.