Economies and Markets: What is the Difference?

It is an easy mistake to make to think that economies and markets are interchangeable words as they tend to move in the same directions and be affected by many of the same data points: interest rates, inflation etc. Therefore,  there is a high correlation between what is happening in an economy or economies and an underlying corresponding index or market. However, they are very separate entities and will, on occasions, move in opposite directions. A recent example of this was in 2022 when the FTSE 250 index fell by 19.7% in the year, compared to the UK economy which grew by 4.1%. There are a multitude of factors to consider when explaining the differing performance; firstly, the basics of what each entity is:

A market or index is a collection of companies or assets grouped together by either size or sector. You can therefore have a market or index that is small or niche or it can be much broader in nature but the key point to note is that there is a restriction on what is contained within the market or index. An economy is much broader; it is an aggregate of all business expenditure, household consumption, government spending and net imports/exports; collectively referred to as Gross Domestic Product (GDP).

The growth rate of an economy is principally determined by objective empirical data and is retrospective; it is looking backwards on the previous period’s GDP versus the period before that, so it is more of a commentary as to what has happened. Conversely, the performance of a market or an index is determined by the price investors are willing to pay for the underlying assets which is subjective and, except for exogenous shocks, largely based on the expected performance of those assets in the future, typically looking ahead six months. Markets are therefore trying to predict the future. In addition, investors will be considering the opportunity cost; what returns could be achieved elsewhere, so the relative expected performance of a market or index compared to others is also relevant in determining the performance of any given market. Collectively, this behaviour by investors can cause a self-fulfilling prophecy – popular assets cause the price to rise whereas unloved assets tend to have price declines causing self-propulsion.

Going back to the 2022 example we can apply the above logic. The economy is growing because it is comparing 2022 data to 2021, a low starting base as recovery from the pandemic is still occurring and the effects of inflation and interest rates rises have yet to be felt. However, for investors, inflation is biting. It is not only hurting the immediate disposable income that is available for investment as costs are higher but is also damaging the outlook going forward. This is happening because knowledge that interest rate rises will inevitably occur to combat the inflation and the associated negative impacts future company revenue forecasts and economic growth. What we are therefore experiencing is the lag effect between economics and market performance. Compounding the disparity is the opportunity cost. With interest rate rises and asset price falls, cash and alternative solutions look comparatively better options than equity type investments in the short term which only drives the momentum of asset price falls further. This is often why markets tend to overshoot both on the upside, when investor confidence is too high, and on downside, when confidence is low.

So why do we need to understand economies and markets? Firstly, it is important to acknowledge the similarities; economic data and news feed plays a key role in determining the performance of both economies and markets and these fundamentals cannot be ignored by analysts and investors. Secondly, what happens in markets or economies cannot be changed and to be a good investor one must look forward to what is likely to happen and not base decisions on what has happened in the past. Lastly, it is important to recognise the importance of sentiment and understand how investors collectively act based on human biases. In separate articles we have discussed biases and latent value; two key factors which help explain why we continue to hold currently unloved assets in the alternatives and property sectors. We believe that there is intrinsic value to be gained for our clients over time that will be realised when sentiment returns as the fundamentals are still there for investors, i.e., high rent collection and inflation proofed income streams.

The nature of markets being at least partly sentiment driven explains why they can be more volatile than economies. One needs to be conscious of the ‘noise’ but not let it entirely drive investment decisions. Monitoring of the fundamental data and acting on long-term value must be the driver of decision making – not just following the crowds.

This article was prepared by James Martin, one of our Financial Planners. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us at FPTeam@city-asset.co.uk.