Published in Business Spectator (Melbourne), 17 July 2014
Later this month, at a conference organised by a global asset management firm, I will be participating in a debate on the moot that investment markets are driven by factors other than financial fundamentals. So far, all I know is that I will be arguing the case for the affirmative. However, I am yet to formulate my arguments properly so I thought I will use this column to give it a first go — and see whether readers might have even better ideas.
Of course, you could be arguing the case against markets driven by cold, hard facts from two entirely different points of view. The first would come from a behavioural finance perspective. It would question whether market participants are even able to rationally process all given information or if they are prone to making systematic mistakes. For example, investors could be reluctant to cut their losses or blindly follow other investors.
I have a lot of sympathy for such behavioural finance analyses, especially where they are confirmed by experimental economics. However, in questioning the role of financial fundamentals for investment markets, behavioural finance only gets you so far.
At least theoretically it would still be possible to properly assess fundamental information if you were aware of your own biases and managed to eliminate them. Or better still, if you knew other market participants’ biases and took advantage of them in making your own decisions. Seen from this angle, existing biases and systematic errors are as much a part of market fundamentals as underlying financial data.
To put it differently, even given the insights from behavioural finance, rational behaviour shaped by market fundamentals would still be possible.
This leads me to the second point of view on why market fundamentals do not drive investment markets. To me, this second point appears far more serious because it does not just make rational assessments more difficult but it actually prevents them. I am talking, of course, about political interference in markets.
Unlike the behavioural biases of market participants, there is not much systematic about political interference. It is also far less predictable, and it can be more powerful by several magnitudes. With market exaggerations triggered by the mistakes of market participants, at least one can usually expect such mistakes to self-correct at some stage. Sooner or later, market players will notice their mistakes and change their behaviour – and if they do not do it themselves, other market players will do it for them.
Every bubble blown up by behaviour that was not driven by fundamentals will deflate at some point. In the wise words of Abraham Lincoln: “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.”
There are no such limits to the distortions caused by politics. Political distortions in markets do not necessarily disappear in time. There is no reason why even the most damaging interferences in markets cannot persist for long periods provided there is enough political will. There is also an added complication with political markets: the causes and effects of political distortions may be quite disparate and almost coincidental.
To give one minor example of such strange political side effects, a chief executive of a large New Zealand power company recently told me about his frustration with his company’s share price movements. The NZ opposition’s plan to nationalise the electricity wholesale market is seen as a major threat to his company, so much so that its share price was not so much driven by financial performance but by political opinion polls in this election year. When a completely unrelated political issue threatened to derail the government’s chances of re-election, it triggered a fall in utility stock prices. Who would call this a fundamentals-driven market?
Of course, this is a small-fry example compared to the larger and much more deliberate political interferences that shape many investment markets today. Governments and central banks have made it almost impossible for investors to base their decisions on fundamentals. Instead, they now have to second-guess the behaviour of political actors.
The European debt crisis provides ample material for anyone wishing to refute the role of market fundamentals. If they had been assessed on their financial fundamentals, arguably quite a few European financial institutions would have disappeared by now. Banks such as Franco-Belgian Dexia only survived thanks to massive, explicit bailouts; others have been kept afloat by more implicit subsidies such as the European Central Bank’s LTRO program. No-one could seriously claim that financial fundamentals explain the current structure of Europe’s banking sector.
Similarly, financial fundamentals do not properly explain the markets for European government bonds. As I have repeatedly written in this column, there are no good fundamental reasons why a country like Greece should be able to borrow any more money, let alone at relatively low yields. There are no good fundamental reasons why the spreads between Europe’s most solid and most profligate governments should have shrunk to just a couple of percentage points.
The only reasons for such outcomes have nothing to do with financial fundamentals but with political interference. The yields on government bonds from the eurozone periphery do not reflect the likelihood of a government default in these countries. They rather reveal the chances of not being bailed out by other institutions should a default be imminent.
It is not just a problem for Europe, to be sure. Where would yields on US government bonds be if there was no Federal Reserve?
To ask this question is to answer it.
In economics, among the first things students learn is about the allocative efficiency of markets. When markets are given a chance to process all relevant information, they will usually deliver efficient outcomes. What we are seeing in many investment markets today has little to do with this world of textbook economics. Investment markets show less of a link with economic realities but political decisions.
In an ideal world, an economic liberal like myself would happily enter a debate supporting the moot that it is financial fundamentals driving investment markets. But it is not an ideal world, neither for economic liberals nor for investment markets.
