Night School, Class 5: How to read the markets

This is an audio transcript of the Behind the Money podcast episode: ‘Night School, Class 5 — How to read the markets’

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Peter Spiegel
Welcome to Behind the Money Night School. I am Peter Spiegel. I’m the US managing editor of the Financial Times. BTM Night School is a special series made in collaboration with Blinkist that will serve as a guide to the US economy in 2023. For tonight’s lesson . . .

Katie Martin
It’s not actually that unusual for markets and real life to be out of sync, but this sort of weird dynamic we have where bad news for real life is good news for markets has been a feature of markets for as long as, well, forever.

Peter Spiegel
We’re talking all types of markets, from stocks to bonds to commodities. We’re joined by the FT’s markets editor Katie Martin and Ethan Wu, a member of the FT’s Wall Street team here in New York. Ethan and Katie will unpack why last year was terrible for stocks, what’s in store for 2023 and what the stock market says or does not say about the strength of the US economy?

So, guys, last year it was a terrible year for the stock market, but it happened at a time the US economy was actually still pretty strong. So can I just start with a big general question, which is why would the stock market go down if the real economy is going up, and why is this opposite direction thing happening?

Ethan Wu
Well, as much as markets love growth, they really, really hate inflation. And that was the big story of last year. It was inflation going up, prices rising across the economy. That destabilises the economy, markets, everything. So the economy was growing. You know, people were spending. Companies were investing. But when you have inflation, it makes it hard to invest for any investor, retail professional, everyone’s job gets harder. And a key reason for that is policymakers respond to inflation by increasing the price of money, by increasing interest rates. And, you know, you could think of interest rates a little bit like what can you earn taking absolutely no risk at all? You know, if you invest in a stock in a company, that company could go bust, could lose money, could, you know, turn out a bad quarter. But interest rates are risk free. You can get, you know, today four and a half per cent, putting it in a savings account. You don’t need to go into the stock market. And so what that does is it leads to a stampede of investors out of the stock market. And that is kind of more or less what happened last year. People looking at the stock market saying, hey, this thing kind of went crazy in 2021 and now we can get 2, 3, 4 per cent absolutely risk free. Why the hell would we stay in stocks?

Peter Spiegel
Katie, let me ask you the same topic, but sort of to broaden it beyond last year, because there’s been a lot of conversation about whether the stock market is still a good barometer for the real economy. The size of the stock market relative to corporate more generally has in some ways gotten smaller. We’ve seen a lot of the big tech start-ups, for instance, in Silicon Valley, they’ve stayed private for a long, long time. So we don’t see them on the public markets. Has that distorted things? Does the stock market still represent the broader economy the way it did 20, 30, 40 years ago?

Katie Martin
It’s not actually that unusual for markets and real life to be out of sync, just out of whack. You know, like, like Ethan was just saying, the one of the things that, that markets love most of all is nice, low interest rates. You know, the Federal Reserve cuts interest rates. Stock markets go higher. So actually, what stock markets love is bad news. So in the middle of Covid, when Covid first broke out, obviously stocks took a bath. But as soon as the Federal Reserve and all the other central banks started just throwing money at the situation, cutting rates really, really hard, there was an incredible rally in the US stock market and, yes, that unravelled last year. So 2022 was an absolute stinker by any sensible measure.

Now, you know, on your point around, do the markets reflect real life from the point of view that a lot of companies stay private now? That’s actually a really interesting point. So one of the things that stock market investors kind of bellyache about, honestly, is we’re kind of starved of good opportunities a lot in the stock market at the moment because a lot of companies do just stay private. You know, those scoundrels in the private equity industry, you know, they get into companies and they keep their claws in them for a really long time. They don’t list them on the stock market as quickly as they used to. So it’s difficult for traditional investors to kind of get a slice of that. And again, that goes back to the point around inflation. It’s the only thing that matters, inflation and interest rates, they’re absolutely dominant here. Private equity companies are flush with cash because it’s been so cheap to borrow for so long that they can afford to buy enormous stakes in companies and just hold on to them until they jolly well want to get rid of them, which might be never. So it’s definitely a factor. But this sort of weird dynamic we have where bad news for real life is good news for markets has been, has been a feature of markets for as long as, well, forever.

Peter Spiegel
OK, well, let’s, let’s get back to the public markets. The purpose in many ways of the, the equity markets is to allocate capital to companies so they can invest and grow. The other sort of knock on effect of that in the real economy is as the markets go up, your average retail investor, your average punter sees their wealth go up and that gets them to be more willing to spend and also juices the US economy. Are those two channels still relevant in the modern markets? Are those are two of the most important things we need to focus on when we think about the stock market’s relevance to the real economy?

Katie Martin
Yeah, definitely. And you know, one of the things, you can probably tell from my accent is that I am a Brit. And one of the things that we find super weird is that Americans buy stocks all the time (laughs). So, you know, Americans got these stimulus checks in the middle of the Covid pandemic from the government. What did you do with them? You went out and bought stocks. Let me tell you something, in a million years, it would not occur to Brits or Europeans to take money (chuckles) from the government and punt around in the stock market with it. We have a completely different kind of culture around retail investment, but there’s a really direct relationship between the performance of stock markets and the wealth of households in the States. Precisely because you have this really active, vibrant kind of stock market where ordinary people buy stocks all the time. Ordinary people make decisions around their 401ks — that is just not something that we do. So there’s definitely a kind of feelgood factor if absolutely nothing else economically in the States when stock markets do well.

Peter Spiegel
Well, since Ethan and I outnumber you because we’re the (Ethan laughs) Americans here, let’s tell our listeners if they are paying attention to the stock markets, what they should be paying attention to. Because the thing that is always, I think on the morning news when we wake up here in the US is the Dow Jones Industrial Average. We’ve been, this is going on since I was a kid, and frankly, before that, the Dow was up, the Dow was down. But the FT doesn’t use the Dow. The FT tends to use the S&P 500. Why does the FT follow the S&P 500 while maybe the morning news show follows the Dow Jones Industrial Average?

Ethan Wu
You know how Coca-Cola used to make soda with cocaine in it?

Peter Spiegel
(Laughs)

Ethan Wu
It is true! It’s a little bit like the Dow, you know, not to smear the good folks at Dow Jones, but, you know, that’s the old recipe. And the S&P 500 is the new recipe. The S&P 500 is constructed the way pretty much all modern indices are constructed, which is bigger companies — Google, Apple, Microsoft, Intel, whatever, Tesla. They get more weight in the index. Smaller companies get less weight. The Dow Jones doesn’t quite work like that. So it’s a little hard to compare kind of apples to apples. But the S&P 500 is kind of considered the marquee benchmark for US markets. But it’s worth noting that it’s not the entire US stock market. There are, you know, thousands of companies — 6,000, something like that — in the US stock market publicly listed. The S&P 500 is the 500 biggest. So these are large companies. It doesn’t include, you know, medium- and small-size companies. It certainly doesn’t include, you know, your local barber shop or other small business. So there’s a kind of broader corporate universe. But in terms of a gauge of the real economy, you should just look at gauges of the real economy. You can Google GDP, you can Google job growth. It takes you 5 seconds, very easy to find these days. So the stock market’s connected to the real economy. But thinking of it as, as a metric, it’s just a little bit too indirect to read unless you really know what you’re talking about.

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Peter Spiegel
All right. So, Katie, we started with perhaps the index that Americans follow too much and it probably shouldn’t. Let me talk about the stock market in particular, because there’s a case to say that the stock market itself is followed too much by your average American, when actually if you look the financial markets much more broadly, it’s actually a relatively small bit of the overall financial markets. The bond market in particular . . . 

Katie Martin
Yeah.

Peter Spiegel
Is far bigger in terms of money invested, in terms of volume traded. Just tell our listeners what the difference is between bond markets and stock markets and what it’s worth watching in bonds. I mean, particularly, I would say, US sovereign bonds or US Treasuries when they’re trying to understand the US economy.

Katie Martin
Yes, so the stock market does throw off some slightly weird signals around the health of the economy. Yet the bond market is in a lot of ways a much more interesting read on the state of the economy. One thing that the government bonds and all bonds, really, but if you look at benchmark government bonds, one thing they really hate is inflation, because, you know, another word for, for the bond market that people throw around is fixed income. These bonds pay you a certain fixed amount of cash every year in form of a what we call a coupon. Now, if inflation goes up, then that amount of fixed payment that you receive effectively goes down, and you’re getting less and less money from these coupon payments all the time. And the eventual amount of money that you get back from, from your investment in the bond, the kind of pay back also is effectively worth less.

So this means that the bond market tells you a lot around what professional investors think is happening to inflation, what they think inflation is going to do next, what they think that the Federal Reserve is going to do in response to inflation. All of that stuff is there to be read in the bond market if you know where to find it. And I think people are sometimes a little bit allergic to the bond market because there are some things about it that seem really confusing. I’m here to tell you if I can get this, anyone can get this. This is not (Peter laughs) complicated stuff. You know, when, when the price of a bond goes up, the yield, which is kind of the reference that everyone uses to gauge how a bond is doing, the yield goes down. Once you’ve got that, you’re away, you’re a bond trader.

Peter Spiegel
And just to dumb it down even more, I mean, I always think of the bond market, and you will correct me because I’m sure I’m oversimplifying it, it’s almost if stocks are I’m buying a piece of the company, bonds are I’m lending a bit of money to a company or to a government.

Katie Martin
Yeah.

Peter Spiegel
And as the price of the bond goes up, the amount of borrowing costs goes down . . . 

Katie Martin
Yeah.

Peter Spiegel
So the price that I am getting paid to loan the money to the government or to the corporates goes down, which is bad for me, basically. That’s the way I tend to think about it. Correct me if I’m wrong here.

Katie Martin
That’s exactly it. So, you know, one of the things around, again, when Covid struck, central banks superhero-style flung themselves into action, slashed interest rates. That meant that it was much, much, much cheaper for companies and governments to borrow. And that was a really important part of the economic recovery from, from that hit from Covid. But it also meant that because those borrowing costs basically hit the floor, investors got stuffed (chuckles). So the returns that they could earn of buying these bonds got absolutely crammed down to pretty much zero, even for quite risky borrowers. So, again, you know, everything is there in the bond market — it’s growth, it’s inflation, it’s interest rates, it’s corporate borrowing, it’s government borrowing. You know, you just need a couple of tiny ingredients to kind of get it. And it’s by far the kind of superior read.

Peter Spiegel
All right, Katie, one more question for you before I go back to Ethan, because I want to talk about other bits of the markets that our listeners might be following or might want pay attention to, and that’s kind of the bit of the markets that you came from. So first of all, commodities, which again, sounds confusing, but actually in terms of inputs, the real economy is pretty important. And then of course your favourite — foreign exchange, which is dollar, pound, yen, all the big exchange between the different currencies. How important are those? And what should our listeners think about when they think about those markets and the real US economy?

Katie Martin
If you believe, as I think you probably should, that the stock market can throw off some slightly iffy signals around what’s going on in the real economy, the commodities market is the real economy. So the price of oil effectively determines how much it costs you to drive your car, how much it costs the next flight that you’re going to be buying, how much it costs you to heat your home. The cost of copper tells you what’s going on with industrial growth because there’s just so much copper that’s needed in construction and manufacturing. It gives you a really good read around what the demand for copper is like. You know, one of the things that happened when Russia launched its full-scale invasion of Ukraine in 2022 is that the gas price and the oil price went absolutely bananas because Europe in particular gets a lot of its energy needs from over in Russia.

So the commodities markets tell you about geopolitics because there is that Russia element. It tells you about food prices. There are just so many fascinating stories that you can unlock there. Currencies, my first love in markets, of course, you know, it pains us, but the most important currency is clearly the dollar (laughter). You know, we have to admit, fine. That’s the kind of north star that kind of guides how all the other currencies behave. But it’s really important to watch how currencies perform, particularly in emerging markets, because a lot of emerging markets have borrowed in dollars because that’s the only currency that the investors want to engage with. The problem with that is that when the dollar pushes higher, suddenly the debt servicing costs for a lot of these countries really get quite painful and it’s quite difficult for them to find enough money to pay these dollars back. So always the thing with the dollar, you know, it’s our currency, your problem is what the Americans always say. But, you know, it really imposes direct economic pain on countries and on companies if they borrow dollars cheaply and then really struggle to pay them back. So currency markets definitely important to watch.

Peter Spiegel
Well, on part of all Americans, Katie, let me apologise (Katie laughs) to you for the pain we’ve inflicted on you by our dollar.

Katie Martin
It’s OK.

Peter Spiegel
Let me turn to Ethan for our last topic. And when it comes to financial markets, we have to touch on crypto. I know there’s a big debate about whether it is a proper security like the other ones we’re talking about. But, Ethan, let me ask you that very question. I mean, obviously a lot of our listeners, a lot of retail investors have been investing in crypto. It’s gained a huge amount of popularity amongst retail investors. Is crypto really a security in the way stocks, bonds, commodities are? And, and if you could touch a little bit about the future of crypto because obviously we had the big collapse of FTX. Bitcoin sold off. And there’s a real question now about what is the future of crypto and if even there is a future of crypto.

Ethan Wu
Ah, yeah. I mean (chuckles) crypto, what, what can you say? Whether it’s a security or something else is a very hotly contested topic. I think you’ll get a lot of views from a lot of different people. The US government seems to believe that it’s either a security or a commodity. I would argue most cryptocurrencies are securities and some — arguably Bitcoin, Ethereum, the two biggest — look a little bit more like commodities. But this is, again, a very contested topic. I think what we can say about crypto is it’s code. Crypto is code, and people have decided that it is worth something. And there are markets that really work, and you can actually trade them for real currency. You know, everything beyond that, I would say, is contested and unsure. This, the future of crypto regulation is being debated everyday in Congress.

But, you know, in terms of the future of crypto, the crypto crash of 2022, the implosion of FTX — these really undermined the credibility that crypto had spent so much time, you know, burnishing in the financial establishment, in the halls of Congress, just among ordinary people. A lot of people have lost money, especially young people, especially people of colour. They’ve lost, you know, really serious sums. And this is not money people were willing or able, you know, to lose. And so I think right now the future of crypto is contested, uncertain, but there are a lot of people with that recent memory of having lost a lot of money. So, you know, I would say the fundamental answer is we don’t know (laughter), which, which, you know, sucks as an answer. But crypto is trying really hard to rebuild from, from the ashes. And we’ll just have to see if they can do it.

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Peter Spiegel
All right, that’s great. Now, I wanna put you guys in the spotlight right now and ask you: if our listeners are sitting here and we’re wrapping up our conversation, what are the three big takeaways that they should have in their head from this conversation? Let me start with number one. Ethan, we start with you.

Ethan Wu
Yeah. So I think the first one is that the stock market and the economy are not the same, but they do interact. And you shouldn’t think of the stock market as a barometer of the real economy, but something feeding into the real economy.

Peter Spiegel
OK, Katie, two . . .

Katie Martin
So I think, look, the stock market matters, but there are so many other markets that really deserve your attention. The US government bond market is the world’s most important market. It sets the price for every other asset on the planet, effectively. And it tells you a huge amount around what the US economy is doing today. And what’s the big brains the professional investors think is going to happen to the US economy tomorrow. I really recommend keeping an eye on it and also keeping an eye on commodities.

Peter Spiegel
OK, and three, Ethan, back to you.

Ethan Wu
Yeah, and just lastly on crypto: the future and the price of crypto, highly contested, highly uncertain. But what we can say is that a tremendous number of investors, especially young people and people of colour, have just lost a lot of money on crypto and buyers should beware.

Peter Spiegel
All right, Katie, I’m gonna put you on the spot here: if our listeners are going to take one thing away to remember from this conversation, what would you say is the one big thing they should think about?

Katie Martin
The one big thing to think about, it’s inflation. And you know what? What I think is going to happen to inflation and what you think is going to happen to inflation and any of our listeners think is going to happen to inflation is just as important as what Jay Powell, who runs the Federal Reserve, thinks is going to happen. Because what we’ve learned over the past couple of years is that nobody understands it. Nobody knows what’s going to happen next. And every opinion around what is going to happen to prices is valid.

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Peter Spiegel
Guys, thank you very much.

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Peter Spiegel
You can find more of Ethan and Katie’s reporting on FT.com. This episode was done in collaboration with Blinkist. If you want to find more conversations and topics like this, check out the Blinkist app. This episode was produced by Zach St Louis. Topher Forhecz is our executive producer. Sound design by Breen Turner and Sam Giovinco. Cheryl Brumley is our global head of audio. Thanks for listening. Class dismissed.

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