Converted Bulls or Convinced Bears?

Economic development and financial markets are closely related, but do not always move in tandem. Markets normally respond to the underlying economic situation and tend to price in the news rather quickly, which is why the market is often assumed to be ahead of the economy. This phenomenon is more evident than ever at turning points.

We argued a few months ago that the effects of the global financial crisis, which dominated most of 2008 and the last five months of the year in particular, will be very present in 2009 as well, but that the main concern will shift from the financial markets to the real economy. During the first four months of the year, we have seen how economic growth forecasts have been revised down significantly (see chart below) and unemployment has increased, while financial markets have been rebounding rather strongly. This trend is perhaps most visible in emerging markets in general and in Russia in particular. The RTS gained over 30% (in USD) during the first four months of the year, while the economic growth forecast for 2009 was revised down by 5.3% between January and April and is now predicted to contract 6%. And the Ukrainian market rallied 50% in April alone, at the same time as it was announced that industrial production dropped almost 32% during the first quarter.

GDP Real Growth 2009 Forecast and IMF Revision


The most commonly asked question these days seems to be if things have bottomed out yet. A general problem with answering that question is that “things” often entails both markets and economies. Indeed, the difference between bears and bulls these days seems to be that the former focuses on the deteriorating macro outlook whereas the latter emphasises the strong performance of financial markets during March and April. Many economies experienced almost unprecedented drops during the first quarter and will contract over the full year. The IMF expects the world economy to contract 1.3% this year and the OECD is even more bearish, predicting global growth to fall by 2.7%. In either case, it will be the largest drop in over 60 years. It is too early to tell when the economies will start growing again, but it is reasonable to believe that the rate of contraction will slow down during the second half of the year and that numbers will start to turn positive some time next year. Emerging markets in Eastern Europe and elsewhere are hard hit by both financial and trade shocks. The financial link manifests itself in the sudden stop of capital inflows following global deleveraging, with net private flows to emerging markets expected to fall from USD 600bn inflows in 2007 to USD 180bn outflows in 2009, according to the IMF. The trade shock comes from the sharp drop in export demand, as well as reduced domestic demand as a result of tighter credit conditions and rising unemployment. Most forecasters have revised down their numbers quite significantly by now and may therefore be surprised on the positive side. But we should not expect any major positive news on the macro front anytime soon as economies have not yet bottomed out.

It is more difficult to determine whether financial markets have turned around. It certainly seems like some markets, especially those classed as emerging, have hit the bottom after strong rallies in March and April. Moreover, market sentiment has improved and volatility (as measured by the VIX index) has more than halved since its peak in late November. There are still a lot of uncertainties in the system, but the positive results of the stress tests on US banks in early May reduced one of the largest concerns in the market. Moreover, the global flu pandemic scare did not manage to break the increasingly positive market sentiment. So although it may be too early for an economist to become a converted bull – and one should not expect markets to continue to rally like in April – it is becoming increasingly late to remain a convinced bear.