Financial markets can tell us a lot about the economic recovery to come, depending on their direction and investor confidence in the future. This is important as we come out of the COVID-19 pandemic. There is a lot of debate on whether the economic recovery will be V-shaped, indicating a short-lived economic slowdown with a rapid return to previous production levels. Or if the recovery will take longer, following a U-shape. Or it might look more like an L-shape, with no short-term recovery and ultimately taking many years, if not decades.
Gold prices have hit a record. This shows how worried investors are about the economic recovery. But the signs aren’t all bad. A review of five important indicators reveals a mix of all three forms of recovery and shows that financial markets are uncertain about the coming economic recovery.
Gold as a store of value is considered a safe asset. As gold does not produce any income in terms of dividends or interest payments, it is avoided during good times (when stocks are in favor). But its intrinsic value is highlighted in times of economic difficulty when gold prices go up.
The price of gold has climbed above the level seen in the years following the global financial crisis of 2007-08, which a number of questions around sovereign debt sustainability. The fact that gold has reached this level again suggests that investors remain wary.
Stock prices fluctuate widely and are generally considered to be one of the riskiest investments. If a business leaves in bankruptcy, investors can lose all their money.
The S&P 500, one of the major stock indexes in the United States, is below the level it started this year, but above the level it was at this time last year. It’s V-shaped, although the upstroke is a bit wobbly and the lingering uncertainty currently prevents a full recovery.
The view of some other markets is less optimistic, however. For example, the UK’s main index, the FTSE 100, is still a long way from regaining its pre-COVID position and has a slightly ascending L-shape.
Copper is the most widely used industrial metal. If goods are being produced and economies are expanding, then copper is in demand and the price of copper will rise. Copper prices fell at the start of the year as China was stranded. There was a new crisis when the coronavirus hit Europe and the United States in March.
China is the world’s largest copper importer and is responsible for nearly 50% of global copper imports. Thus, the price of copper is largely driven by demand from China and the increase in the price from the low point around March 19 is consistent with the easing of the shutdown period in China. So, the copper recovery shows signs of an elongated V shape, possibly stretching into a U.
If the goods are manufactured, they must then be shipped to their final destination. The Baltic Dry Index is a composite index of the cost of shipping major raw materials. If the goods are shipped worldwide from manufacturer to consumer, the index will increase.
This index is now not only above its initial US / European lockdown level, but has also returned to levels it was before China’s shutdown. This suggests an increase in manufacturing output and hope for exports. The dip at the end of the chart, however, signals a warning that uncertainty persists.
Like gold, government bonds are another asset considered safer to invest in during crises, since governments (usually) do not go bankrupt and pay off debts. When investors worry about the future economic outlook, they buy government bonds, making those bonds more expensive and reducing the yield they pay (government bonds pay a fixed interest payment in cash) .
Bond yields are also affected by the monetary policy operated by the central bank, with lower interest rates set in weaker economic climates to encourage people to spend. So, we can compare the yields of bonds of different lengths (known as term structure), where a higher yield indicates a more positive outlook.
We can take a slightly longer time perspective and see from the chart above that, on the one hand, the recovery in terms structure indicates a recovery. But, on the other hand, the rise seems to have stagnated, indicating uncertainty going forward.
Overall, the evidence suggests that investors are unsure. The fact that they buy inventory and goods used in production is a sign of hope that the world economy will recover quickly. But gold prices also give a dose of realism.
David McMillan is Professor of Finance at the University of Stirling.