Understanding Financial Markets: Part 1

Anyoption analyst Brett Chatz takes an interesting look at explaining the inter-connectivity of global financial markets. For more of Brett’s research see the Anyoption blog.


If we have learned anything from bull markets and bear markets, it is this: neither of them lasts indefinitely.

This facts precipitating the global financial crisis of 2008 were covered in the financial press, ad-nauseam. Markets are cyclical in nature, they follow trends and there are often obvious or obscure signs about which way things are going to move. Does this mean that there is a way to anticipate with 100% accuracy which way a stock, commodity, index or currency pair is going to move? Absolutely not. However, it’s not about absolutes as much as it is about general trends.

Long-Term Appreciation of Financial Assets or Short-Term Gains?

Dow Jones 10 year chart

Whenever discussion of the stock market comes up, most every trader or investor thinks about the long-term appreciation of an underlying financial asset. Traditional thinking dictates that you invest a certain amount of capital in a stock, currency, commodity or index and you wait for that underlying asset to appreciate over a given period of time. All the while, you are subject to the rules and regulations, costs and commissions, and hierarchical structure of the brokerage that you’re trading with. Oftentimes there will be costs per trade, monthly management fees, commissions and so forth. These cost considerations are important to bear in mind especially if you’re trading on a limited budget – which most people are in today’s times.

When the global economy was shaken to its core in 2008, investors were sent scrambling for cover. Trillions of dollars were erased from global markets in short order, and the declines were so cataclysmic that they sent emerging markets into a recession, precipitated steep depreciation of currencies like the South African rand, the Turkish lira, the Brazilian real, the Venezuelan bolivar, theMalaysian ringgit, and the Russian ruble. The impact of the collapse of Lehman Brothers on Wall Street or Fannie Mae and Freddie Mac had cataclysmic repercussions on markets from New York to London, Paris, Moscow, Tokyo, Johannesburg, São Paulo, Bogotá and beyond.

Why Bubbles in the US Matter Elsewhere

investment bubbles

You may be wondering why a housing bubble that bursts has such incredible shockwave potential, that it can virtually destroy the global economy? The financial markets exist in a hierarchical structure. The world is divided into developed economies and emerging markets. The US is the world’s #1 economy with the largest GDP and the most skilled workforce on the planet. Even with China’s rapid rise to #2 biggest economy in the world, it still pales in comparison to the buying power of the US. That’s why the USD is the world’s reserve currency by a long margin, even though other currencies in the British pound, Swiss Franc, euro, Chinese renminbi and the Canadian dollarhave a part to play too.

What happens on US financial markets is central to the stability of the global financial markets. More trading activity takes place on Wall Street than any other major financial bourse in the world. Investors and brokerage houses, fund managers, day traders and speculators all look to Wall Street for their cues on how to invest or trade on a day-to-day basis. When major financial corporations are involved in major malfeasance and it results in economic chaos, the shockwaves impact on major averages the world over. This is precisely what happened in 2008 and 2009.

Think of the developed economies and the emerging market economies as a human body. When the human body is exposed to harsh elements such as bitter cold, the extremities – the emerging markets – are the first to suffer. The body wants to maintain the functionality of its core components – the heart, lungs, kidneys, liver, pancreas, and the brain. These are akin to the Dow Jones Industrial Average, the NASDAQ composite index, and the S&P 500. And since Europe is considered part and parcel of the developed world, the CAC 40, the DAX, the FTSE 100 index and others are also considered the core of the human body. Much the same is true of the Nikkei 225index in Tokyo, with Japan being the world’s third-largest economy.

public debt worldwide

Developed Economies Hold Concentration of Global Capital

By now you starting to get an understanding of where the money is concentrated in the world. This is important in recessionary economic times because the most successful economies are the developed economies. They are stable and prosperous as is evident by economic indicators such as GDP per capita, GDP, balance of trade, services and manufacturing data etc. In other words, the sheer volume of global trade that is concentrated with the world’s premier economies far outweighs that of other economies that do not compete at the same level. When the global financial crisis hit, everybody panicked. When investors panic they withdraw their assets from emerging market economies. This is known as capital flight. The reason that emerging markets are deemed unstable is that they have a generally unstable political climate, weak infrastructure, lax financial rules and regulations, higher levels of corruption, unstable currencies and a lack of sufficient entrepreneurial flair. While this may be an over exaggeration of certain components of their economies, it generally holds true.

capital flight

When money exits emerging market economies, those countries suffer additional shocks in the form of capital flight. When the major buyers of commodities like iron ore, copper, coal, crude oil and natural gas are decreasing, their imports from emerging market economies (EM economies) suffer major economic contractions. And once major mining companies such as Glencore plc,Anglo American, BHP Billiton, Rio Tinto plc, British Petroleum, Shell Oil and other multinational corporations find their production quotas declining, corporate profitability declines accordingly. This leads to divestiture, job losses, economic contractions and ultimately currency weakness for the country that they are operating in. This is once again an oversimplification of what happens in emerging market economies when the world’s leading economies – the developed economies – go through recessionary times.

Stay tuned next week for Part 2 of the Understanding Financial Markets series.

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