Stocks risk a nasty tumble as investors turn a blind eye to Ukraine and Taiwan

Ukrainian servicemen fire a mortar shell towards Russian troops at the frontline position near the Vuhledar town, amid Russia's attack on Ukraine, in Donetsk region, Ukraine February 11, 2023. REUTERS/Marko Djurica - REUTERS/Marko DjuricaIf you are not a regular devotee of stock market movements, you may not have noticed that, before dipping a bit on Friday, this week the FTSE 100 stock market index hit new all-time highs.

This followed a relatively good performance last year. Although London’s leading index only rose by less than 1pc over 2022, the American S&P 500 stock market index fell by 20pc. Many good judges believe that since UK assets look comparatively cheap, this strong performance may continue.

Yet this message hardly gels with the intense strain on living standards that many people are experiencing or the supposedly dire state of the British economy.

What on earth is going on? Should we be encouraged about our economic prospects by the fact that the stock market is strong?

The FTSE 100 is not the same as the whole UK stock market. Its constituents are the 100 largest UK listed firms by the size of their stock market capitalisation. So far this calendar year the FTSE is up by over 6pc and the FTSE 250 index, which consists of the 250 next largest firms by capitalisation, is up over 7pc. But since the start of last year the latter is still down by about 14pc.

Moreover, the very large firms in the FTSE are on the whole internationally focused. They derive nearly 80pc of their earnings from overseas.

By contrast, the constituents of the FTSE 250 are much more focused on the UK economy. Accordingly, when the FTSE 100 performs strongly, it is more likely to reflect the market’s view of the world economy, often heavily influenced by news from the United States, than its view about UK economic prospects.

By contrast, strength of the FTSE 250 index does reflect the market’s view about UK prospects – albeit focused on corporate profits and influenced by movements in UK bond yields and interest rates.

These latter factors also have a major bearing on the performance of two other key asset types – residential and commercial property which, in contrast to the FTSE 100, have been weak. UK residential house prices are 4pc down from their peak last year. Likewise, commercial property prices are down by over 17pc.

In fact, there has recently been some reason for modest good cheer about both the world economy and the UK.

The world economy looks to be stronger than most investors dared hope just a few months ago yet US interest rates seem to be not far off peaking.

In the UK, although things still look dire for consumers and for many businesses, more analysts are coming round to the view that the still likely UK recession this year will probably be pretty shallow.

It is widely believed that markets are good at foreseeing the future. Some people even attribute semi-magical powers to them. I think this is seriously misjudged.

Markets are generally good at evaluating available information about the quantifiable near future. But they are hopeless at evaluating the really big questions, especially when these range outside the narrow financial and economic ambit.

Why should this be surprising? There are some things that are genuinely unknowable by any of us – and that includes even the most talented and far-sighted of stock market analysts and investors.

Accordingly, if the FTSE 100 index carries on rising strongly, this will tell us nothing about the likely outcome of the war in Ukraine or the difficult situation over Taiwan, to name but two known unknowns.

Faced with such fundamental uncertainties, financial markets have a tendency to turn a blind eye and hope for the best. Then, if something really nasty crops up, they can take a very nasty tumble.

For all the pretence at rational calculation, when it comes to unknowables, how the markets behave comes down to those primaeval forces of fear, hope, greed, confidence and caution.

And, just at the moment, the geopolitical scene offers plenty of scope for surprises that can catch the market off guard, and for sharp changes in the market mood about the likelihood and severity of such developments and their impact.

At a more prosaic level, next week sees the release of some statistics on the UK economy that should give the markets food for thought, especially about the likely evolution of the Bank of England’s interest rate policy.

On Tuesday comes labour market data that will, amongst other things, reveal the latest on pay inflation. The Bank will probably be looking closely at the rate of increase of regular pay in the private sector, which has recently been running at 7.2pc.

It is probably too soon to hope for this to ease back but any further acceleration would set alarm bells ringing in Threadneedle Street.

On Wednesday, we get the inflation data. There is a good chance that the headline rate of CPI inflation will fall back from December’s 10.5pc to perhaps something like 10.2pc in January. (But be warned that there is a greater than usual chance of a big surprise this month as the numbers will be based on different weights for the components of the price index.)

The Bank’s attention will be focused primarily on the rate of core inflation, particularly core inflation in the services sector. That is the measure that is heavily influenced by pay inflation and is determined largely by forces in the UK economy, over which the Bank can be expected to exert some influence, rather than by global factors which the Bank is powerless to affect.

UK financial markets are currently expecting inflation pressures to subside fairly readily and, accordingly, for the Bank Rate to peak at no more than 4.25pc - 4.5pc, which I suspect is too low. Current market values of heavily UK-focused businesses reflect that interest rate expectation.

Economic data this week could give the market reason to question this assessment. If that were to happen, those UK-focused businesses could experience a wobble in their share prices.

Roger Bootle is chairman of Capital Economics
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