Tag: speculation

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Stock markets rise despite the recession. Why?

Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.

When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.

The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).

But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?

Quantitative easing

In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).

But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.

Confidence

Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).

But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.

Speculation

A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.

If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.

There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.

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Questions

  1. Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
  2. What determines the price elasticity of demand for shares?
  3. Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
  4. Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
  5. What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
  6. Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.
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A Keynesian ‘shock and awe’ boost from the Budget

With promises by the newly elected Conservative government to increase investment expenditure on health, education, innovation and infrastructure, it was expected that Rishi Sunak’s first Budget would be strongly expansionary. In fact, it turned out to be two Budgets in one – both giving a massive fiscal boost.

An emergency Budget

The first part of the Budget was a short-term emergency response to the explosive spread of the coronavirus. An extra £12 billion is to be spent on the NHS and other public services. Whether this will be anything like enough to cope with the effects of the pandemic as businesses fail and people lose their jobs remains to be seen. (See the blog A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak.)

A key issue is just how quickly the money can be spent. How quickly can you train health professionals or produce more ventilators or provide extra hospital beds?

This emergency part of the Budget was co-ordinated with the Bank of England’s decision to cut Bank Rate from 0.75% to 0.25%.

This combined fiscal and monetary response to the crisis was further enhanced by the agreement of central banks on 15 March to boost world liquidity by increasing the supply of US dollars through large-scale quantitative easing. The US central bank, the Federal Reserve, also cut its main federal funds rate by one percentage point from 1–1.25% to 0–0.25%.

The planned Budget

The second part of the Budget is to raise government investment by 9% in real terms over the next four years, bringing overall government expenditure to 41% of GDP, financed largely by extra borrowing. As the IFS observes, “That is above its pre-crisis level and bigger than at any point between the mid 1980s and the start of the financial crisis.”

But despite this rise in the proportion of government spending to GDP, in other respects the spending plans are less expansionary than they may appear. Increases in current spending on health, education and defence had already been promised. This leaves other departments, such as social security, facing cuts, or at least no increase. And when compared with 2010/11 levels, if you exclude health, government current spending per head of the population will around 14% lower, or 19% lower once you account for spending that replaces EU funding.

The Chancellor’s hope is that, by focusing on investment, there will be a supply-side effect as well as a demand-side boost. If increases in aggregate demand are balanced by increases in aggregate supply, such a policy would not be inflationary in the long run. But in the light of the considerable uncertainty of the effects of the coronavirus, the plans may well require significant adjustment in the Autumn Budget – or earlier.

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Official documentation

Questions

  1. To what extent is this Budget ‘Keynesian’?
  2. Is the extra government expenditure likely to crowd out private expenditure? Explain.
  3. Demonstrate the desired long-term economic effect of the infrastructure policy using either an AD/AS diagram or a DAD/DAS diagram.
  4. How is the coronavirus pandemic likely to affect potential GDP in (a) the short run (b) the long run?
  5. Why is public-sector debt likely to soar over the next four years while annual government debt interest payments are likely to continue their gentle decline?
  6. What is missing from the Budget that you feel ought to have been included? Explain why.
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A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak

The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.

The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.

Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.

Economic uncertainty

With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.

Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.

Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.

Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.

Longer-term effects

Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.

While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.

How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.

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Questions

  1. Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
  2. Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
  3. What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
  4. What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
  5. Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
  6. What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
  7. What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
  8. Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.
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Evolving Economics

The linked article below, by Evan Davis, assesses the state of economics. He argues that economics has had some major successes over the years in providing a framework for understanding how economies function and how to increase incomes and well-being more generally.

Over the last few decades, economists have …had an influence over every aspect of our lives. …And during this era in which economists have reigned, the world has notched up some marked successes. The reduction in the proportion of human beings living in abject poverty over the last thirty years has been extraordinary.

With the development of concepts such as opportunity cost, the prisoners’ dilemma, comparative advantage and the paradox of thrift, economics has helped to shape the way policymakers perceive economic issues and policies.

These concepts are ‘threshold concepts’. Understanding and being able to relate and apply these core economic concepts helps you to ‘think like an economist’ and to relate the different parts of the subject to each other. Both Economics (10th edition) and Essentials of Economics (8th edition) examine 15 of these threshold concepts. Each time a threshold concept is used in the text, a ‘TC’ icon appears in the margin with the appropriate number. By locating them in this way, you can see their use in a variety of contexts.

But despite the insights provided by traditional economics into the various problems that society faces, the discipline of economics has faced criticism, especially since the financial crisis, which most economists did not foresee.

Even Davis identifies two major shortcomings of the discipline – both beginning with ‘C’. ‘One is complexity, the other is community.’

In terms of complexity, the criticism is that economic models are often based on simplistic assumptions, such as ‘rational maximising behaviour’. This might make it easier to express the models mathematically, but mathematical elegance does not necessarily translate into predictive accuracy. Such models do not capture the ‘messiness’ of the real world.

These models have a certain theoretical elegance but there is now an increasing sense that economies do not evolve along a well-defined mathematical path, but in a far more messy way. The individual players within the economy face radical uncertainty; they adapt and learn as they go; they watch what everybody else does. The economy stumbles along in a process of slow discovery, full of feedback loops.

As far as ‘community’ is concerned, people do not just act as self-interested individuals. Their actions are often governed by how other people behave and also by how their own actions will affect other people, such as family, friends, colleagues or society more generally.

And the same applies to firms. They will be influenced by various other firms, such as competitors, trend setters and suppliers and also by a range of stakeholders – not just shareholders, but also workers, customers, local communities, etc. A firm’s aim is thus unlikely to be simple short-term profit maximisation.

And this broader set of interests translates into policy. The neoliberal free-market, laissez-faire approach to policy is challenged by the desire to take account of broader questions of equity, community and social justice. However privately efficient a free market is, it does not take account of the full social and environmental costs and benefits of firms’ and consumers’ actions or a fair distribution of income and wealth.

It would be wrong, however, to say that economics has not responded to these complexities and concerns. The analysis of externalities, income distribution, incentives, herd behaviour, uncertainty, speculation, cumulative causation and institutional values and biases are increasingly embedded in the economics curriculum and in economic research. What is more, behavioural economics is becoming increasingly mainstream in examining the behaviour of consumers, workers, firms and government. We have tried to reflect these developments in successive editions of our four textbooks.

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Questions

  1. Write a brief defence of traditional economic analysis (i.e. that based on the assumption of ‘rational economic behaviour’).
  2. What are the shortcomings of traditional economic analysis?
  3. What is meant by ‘behavioural economics’ and how does it address the concerns raised in Evan Davis’ article?
  4. How is herd behaviour relevant to explaining macroeconomic fluctuations?
  5. Identify various stakeholder groups of an energy company. What influence are they likely to have on the company’s behaviour?
  6. In an era of social media, web-based information and e-commerce, why might it be necessary to rethink the concept of GDP and its measurement?
  7. What is meant by an efficient stock market? Why may the stock market not be efficient?
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Who Tweets Wins

Today’s title is inspired from the British Special Air Service (SAS) famous catchphrase, ‘Who Dares Wins’ – similar variations of which have been adopted by several elite army units around the world. The motto is often credited to the founder of the SAS, Sir David Stirling (although similar phrases can be traced back to ancient Rome – including ‘qui audet adipiscitur’, which is Latin for ‘who dares wins’). The motto was used to inspire and remind soldiers that to successfully accomplish difficult missions, one has to take risks (Geraghty, 1980).

In the world of economics and finance, the concept of risk is endemic to investments and to making decisions in an uncertain world. The ‘no free lunch’ principle in finance, for instance, asserts that it is not possible to achieve exceptional returns over the long term without accepting substantial risk (Schachermayer, 2008).

Undoubtedly, one of the riskiest investment instruments you can currently get your hands on is cryptocurrencies. The most well-known of them is Bitcoin (BTC), and its price has varied spectacularly over the past ten years – more than any other asset I have laid my eyes on in my lifetime.

The first published exchange rate of BTC against the US dollar dates back to 5 October 2009 and it shows $1 to be exchangeable for 1309.03 BTC. On 15 December 2017, 1 BTC was traded for $17,900. But then, a year later the exchange rate was down to just over $1 = $3,500. Now, if this is not volatility I don’t know what is!

In such a market, wouldn’t it be wonderful if you could somehow predict changes in market sentiment and volatility trends? In a hot-off-the press article, Shen et al (2019) assert that it may be possible to predict changes in trading volumes and realised volatility of BTC by using the number of BTC-related tweets as a measure of attention. The authors source Twitter data on Bitcoin from BitInfoCharts.com and tick data from Bitstamp, one of the most popular and liquid BTC exchanges, over the period 4/9/2014 to 31/8/2018.

According to the authors:

This measure of investor attention should be more informed than that of Google Trends and therefore may reflect the attention Bitcoin is receiving from more informed investors. We find that the volume of tweets are significant drivers of realised [price] volatility (RV) and trading volume, which is supported by linear and nonlinear Granger causality tests.

They find that, according to Granger causality tests, for the period from 4/9/2014 to 8/10/2017, past days’ tweeting activity influences (or at least forecasts) trading volume. While from 9/10/2017 to 31/8/2018, previous tweets are significant drivers/forecasters of not only trading volume but also realised price volatility.

And before you reach out for your smartphone, let me clarify that, although previous days’ tweets are found in this paper to be good predictors of realised price volatility and trading volume, they have no significant effect on the returns of Bitcoin.

Article

References

Questions

  1. Explain how the number of tweets can be used to gauge investors’ intentions and how it can be linked to changes in trading volume.
  2. Using Google Scholar, make a list of articles that have used Twitter and Google Trends to predict returns, volatility and trading volume in financial markets. Present and discuss your findings.
  3. Would you invest in Bitcoin? Why yes? Why no?