Last Updated on December 2, 2024
Overview
It comes as little surprise that capital markets and the broader economy are usually talked about in the same context. After all, the economy and capital markets are related – the well-being of one usually affects the other.
Although the two share some overlap, countless investors still make the mistake of clumping the two concepts together as meaning the same thing.
Just because two things are related does not mean they are interchangeable – this is especially true when it comes to the economy and capital markets.
What is the Economy, Anyways?
The first hurdle that needs to be overcome is defining the word “economy”.
Of course, you can open any introductory economics textbook, and chances are they will give you a very technical definition of what an “economy” is, but these definitions are usually far beyond the scope of what an investor needs to know.
I have come to like the definition given by Ray Dalio, an American billionaire investor and founder of Bridgewater Associates, in his masterful YouTube video “How The Economic Machine Works by Ray Dalio”. He gave the following definition of an economy:
“An economy is simply the sum of the transactions that make it up and a transaction is a very simple thing…..every time you buy something, you create a transaction.”
In other words, the aggregate of all transactions is what makes up the economy. For example, every transaction that takes place within the borders of Canada is what constitutes the Canadian economy. These transactions can range anywhere from the purchase of a barrel of oil all the way to the purchase of clothing.
Now that we’ve cleared our first hurdle, the second challenge is figuring out what metric (or metrics) are used to “measure” economic output.
By far the most widely used metric to measure economic activity is Gross Domestic Product (GDP). The Organization for Economic Co-operation and Development (OECD) gives the following definition for GDP:
“Gross domestic product (GDP) is the standard measure of the value-added created through the production of goods and services in a country during a certain period. As such, it also measures the income earned from that production, or the total amount spent on final goods and services (less imports).”
A country’s economic size (and by extension, their economic influence) is almost always measured exclusively in GDP. Not only that, but a country’s “economic growth” is usually just another way of saying “a country’s GDP growth.”
Other factors such as unemployment rates, consumer spending, and consumer borrowing are also commonly used metrics when assessing economic health.
What are Capital Markets?
Before we look at the definition of capital markets, we must understand some things first.
First, we need to understand what the term “market” means. According to the Merriam-Webster dictionary, a “market” is defined as:
“a meeting together of people for the purpose of trade by private purchase and sale and usually not by auction.“
As you may have guessed (or are already aware of), there are hundreds, if not thousands, of different markets all trading different things: food, clothes, specialized equipment, etc.
Naturally, this also means that there exists a market specifically for the trade of financial products such as money, bonds, and equities. Such a market is called a financial market.
Within financial markets, there exists a “sub-market” called capital markets. As the name implies, in a capital market, there are two parties: those who seek capital, and those who have capital and want to gain a return from it.
For example, a company that issues shares is the party that is seeking capital, whereas investors represent the party in possession of capital and are looking for places to invest.
The capital markets most people are familiar with are the stock and bond markets.
One of the First Problems That Come to Mind
So, we know that an economy is the sum of all transactions that take place within some specified boundary (a country, a continent, the whole world), and the most prominent measure of economic activity is the monetary value of all goods and services produced in a certain period (i.e., GDP).
On the other hand, capital markets are places where those who seek capital (companies) and those who possess capital (investors) come together to trade. An investor buying shares of a company is an example of a capital markets transaction.
As we can see, the economy and capital markets cover two entirely different areas. One deals with the sum of all transactions, whereas the other deals only with the purchase and sale of capital.
Empirical observations suggest that the two are related to some extent: when economic activity is down, capital markets are usually just as quick in their descent, and vice versa.
Sure, a strong economy is usually accompanied by equally strong capital markets, but that doesn’t mean the relationship between the two is as simple as “if one goes up, so should the other”.
The broader economy and capital markets are both very complicated machines. It’s still debatable as to how they relate to one another, yet so many investors still believe that the connection between the two isn’t as complex as it seems.
A Not-so Straightforward Connection
Based on what I’ve seen, many people view the relationship between the economy and capital markets as something that is relatively straightforward. Let me explain:
When economic conditions are strong (healthy GDP figures, low unemployment, high levels of consumer spending), some people make the connection that companies are also thriving, meaning that their stock price should go up, prompting people to invest.
As a result, people quickly expect a positive feedback loop: as companies receive more investment dollars, they can expand their operations, leading to even more revenue/profit, resulting in an even stronger business, meaning more investment.
On the other hand, when GDP figures are less than forecasted, unemployment is high, and consumer spending is low, this should mean that the business community isn’t doing so well either, causing stock prices to sink.
For most people, a “strong economy” is usually taken as meaning “market indices are at all-time highs”. Similarly, when capital markets are down, people are just as fast to declare that “the economy is in shambles!”
The logic goes: If economic activity is strong, then capital markets should be strong. If one is weak, then the other should be weak as well.
Like I said before, the relationship between the economy and capital markets is complex, so expecting any sort of rationality between how the two are related is a bit naïve.
Just because the economy is doing well doesn’t automatically mean capital markets will suddenly soar. Similarly, it’s not unheard of for capital markets to be booming while the economy is in the doldrums – this was observed in late 2020 and early 2021 as capital markets around the world soared while millions of people around the world have yet to financially recover from COVID-19.
Looking specifically at stocks, some investors believe that the primary force behind a company’s stock price is a strong economy: if economic conditions are favourable, then it should follow that stock prices will increase as well.
Stock prices are influenced by current economic conditions, yes, but it’s important to remember that several factors contribute to the price of stocks. A stock’s price is a mixture of both present and future factors.
To make matters even more complicated, there is no clear “formula” that determines which factors influence stock prices and their relative weightings (i.e., how much each factor influences price). That’s why no investor can say with absolute certainty what a stock’s price will be in the future – the best they can hope for is an approximate price range.
Saying that asset prices will increase simply because current economic conditions are strong is a very dangerous way of thinking.
Why This is Important for Investors
It’s easy for investors to succumb to the temptation of buying whatever financial assets they can get their hands on simply because the broader economy is doing well.
Conversely, it’s also tempting to become jittery and proceed to panic sell just because an investor is constantly surrounded by economic doom and gloom.
Investors need to remember that although the economy and capital markets are related to some extent, they are two distinct entities that should not be conflated.
Just because current economic conditions are favourable doesn’t mean every stock or bond on the capital markets are worth purchasing. On the flip side, just because the economy is in ruins doesn’t mean that there no are no excellent investment opportunities waiting to be unearthed.
After the fallout from the 2007-2008 Global Financial Crisis, the economy and capital markets were in shambles. Investors in the U.S. were wary of buying any sort of American financial assets.
Warren Buffett, not one to be easily deterred, wrote an Op-Ed in the New York Times explaining why he still planned to invest in America and encouraged other investors to do the same.
He recognized that although the economy had clearly been rocked, there were still opportunities waiting to be seized on the capital markets. Not everything was doom and gloom.
Investors need to remember that investing and emotions go hand-in-hand, for better or for worse. Capital markets are so irrational because they are heavily influenced by the emotions of the participants. All it takes to make capital markets rise and fall are the mood swings of those involved in the market.
Capital markets represent a small portion of a much larger whole. Just because the whole is healthy doesn’t mean every individual part is healthy as well, and vice versa.
Wrapping Up
The economy and capital markets are talked about very frequently, so it comes as little surprise that some people have begun to talk about these two things as if they are interchangeable.
It’s tempting to think that, because the two share some overlap, then they should influence one another. A strong economy begets robust capital markets, and struggling capital markets indicate that the economy will soon follow suit.
However, the relationship between the economy and capital markets isn’t as black and white as some investors believe – both are very complex, so expecting a simple relationship between the two is just naïve.
If the economy is up, investors must refrain from going an unhinged asset buying spree. If the economy is down, investors must resist the urge of succumbing to the pessimism, lest they want to miss out on excellent investment opportunities waiting to be seized.
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