Why stock markets are up but the economy is down

Making sense of the current risk situation can be tricky in an environment where dire economic data is released alongside news stock markets are booming. Financial markets sometimes have an odd relationship with the real economy, like now, and here’s why.

The real economy is made up of all the goods and services we produce and consume, across all individuals, companies, and the government.

On the other hand, stock markets are only exchanges for the buying, selling and issuance of shares in a limited number of typically large, well-capitalised companies.

Smaller businesses tend not to be listed on a stock market, but have a hugely important role, in the real economy, as employers and sources of income. While a publicly listed giant like Netflix may be doing well, sending stock markets higher, it could be a very different story for your struggling local highstreet of family-run bakers, butchers and greengrocers.

One reason for this is it is fairly easy for companies listed on a stock market to raise extra cash if they need it, by issuing more shares, or borrowing from capital markets – options not available to smaller businesses.

Life for listed companies may have been made even easier during the Covid-19 crisis, as central banks, like the Bank of England in the UK, have slashed interest rates, and restarted stimulus programmes such as quantitative easing.

Low interest rates and the money generated by QE result in a surge in investment because banks are awash with cheap cash that they lend out. This can lead to an increase in speculative buying of shares and asset-price inflation that sends stock markets higher, and that can hide what is really going on in the wider economy.

Higher stock markets can make ordinary people feel more secure, creating what is known as ‘positive sentiment’ that our pensions and investments will perform well. But to gauge the direction of the real economy it is often more important to look at how companies are behaving.

Sectors hit particularly hard by the global shutdowns and restrictions to curb coronavirus – travel and tourism, car manufacturers, hospitality and retail – have already laid off tens of thousands of workers, signalling they think trading conditions won’t improve in the short to medium term.

When people are unemployed or are worried about their job security, they spend less and save more in case they lose their job. Smaller companies, not those listed on the stock market, struggle most if their customer numbers dwindle, putting the livelihoods of owners and employees at risk, with many already being forced to close.

In the United States small firms make up about half of private sector employment and 44% of economic activity, according to the U.S. Small Business Administration. In the UK it is around 60% of jobs and half of private sector turnover. When small firms go bust, that is a lot of people out of work, and a lot less money flowing into the economy.

Less buying (consumption) means less needs to be produced, requiring less workers to make goods or carry out services. So more people are made redundant from their jobs, creating a vicious cycle of low demand, low consumption and low production. That is what really hurts economies, and individuals’ personal finances.

A soaring stock market can distract from problems in the real economy.

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