Rising oil prices. Higher interest rates. Tariffs and surging inflation. Wars that are always a one deal away from ending. This is a broad summary of the economic and financial headlines of the last one year. One would guess, incorrectly, that stock markets around the world have crashed this year.
But the true picture is mixed. The Nifty index is down 11% year to date. In contrast, the S&P 500 Index is up 12% year to date. European indices have experienced modest gains this year. Asian indices have mixed outcomes.
The Role of AI
Much of the divergence in the market performance can be explained by AI. The US has significant AI exposure, India does not. South Korea, one of the best performing markets this year, has significant AI exposure. The market optimism for AI is dwarfing other concerns. Indeed, prior to the conflict, most financial market headlines were about AI. AI still dominates the news, but less than before.
The AI story is one based on the potential for future growth. Current valuations are high and reflect expectations of high future growth. Two major AI companies, Anthropic and Open AI, are expected to go public within the next 12 months. They will likely trade at very high multiples. If AI turns out to improve productivity in a meaningful way, these expectations will materialize. If not, the AI boom will turn into an AI bust.
The AI boom may also slow down on its own. Recently, there has been talk of slowing down development. There are natural concerns around safety. The founders of AI companies themselves are warning of trouble ahead.
The West Asia Conflict
The bigger question is why the West Asia conflict has not caused major market disruptions. The first reason is expectations. Throughout the last seven months, the expectation has always been that an end to the conflict is near. Just this week, the US and Iran held indirect talks at the UN summit.
The assumption of investors has always been that both countries have more to lose by continuing the conflict. Both countries gain economically if a deal is reached. Other countries in the region are also gain if a deal is reached. Thus, all incentives point to a near term end to the conflict. Stock markets reflect investor expectations about the future. If investors are optimistic, markets will follow.
The second reason is that oil markets have been well supplied. This is because inventories have been drawn down globally. For example, the strategic petroleum reserve in the US is down by 30% in the last six months. It is at its lowest levels since the early 1980s. China has been drawing down its own reserves and reducing imports. The drawdown cannot continue indefinitely. But for now, it has prevented oil prices from rising too much. Oil prices are not high enough to cause a global recession and market crash.
The Crash in the Treasury Market
The third reason is more speculative. It is possible that stock market investors are simply making a mistake. They are overly optimistic, and a market crash is on its way. One piece of evidence supporting this hypothesis is the US treasury market. In the last few weeks, the US treasury market has dropped dramatically. The ten-year yield is now close to 5.2%. The last time the ten-year yield crossed 5% was before the global financial crisis of 2008.
The fall in bond markets is a sign that bond investors are concerned. In fact, the bond market movements track the West Asia conflict closely. And the end of February this year, the ten-year yield was just under 4%. It has been rising steadily ever since. The only sustained drop this year was during May and June, when the conflict looked like it was about to end.
Thus, it is not the case that the conflict has not affected markets in a significant way. Rather, the bond market has dropped in a meaningful way. The equity market has not. Why do we have this divergence?
A major difference between equity and bond markets is the participants. Bond markets consist of mostly institutional investors. Equity markets have a much larger share of retail investors. This matters because retail investors are more likely to be overly optimistic. On average, retail investors have lower returns than institutional investors.
Right now, institutional investors are more worried than retail investors. Historically, institutional investors have a better track record. But of course, that does not imply the same for future.
Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.