There is a lot more to financial markets – their history, function and the multi-faceted roles they play – than what you see on the nightly TV finance report. Here is what you need to know.
Overview:
For all the sheer size, influence and ubiquity of financial markets in the lives of Australians and people everywhere in the 21st century, it is remarkable how few of us really understand how they function and the multiple roles they play.
Of course, we are all aware of the nightly finance report on news bulletins and the routine references to benchmark indices like the S&P 500, individual company shares, interest rates, commodity prices and foreign exchange rates.
But there is so much more to financial markets than a daily rollcall of what was up and what was down. Such boilerplate coverage fails to reflect that these are vast, dynamic systems which play a critical role in the global economy.
More importantly, a shallow focus on winners and losers day-to-day misses what drives long-term returns term in a capitalist economy and the opportunities available for professionally advised individuals and businesses to participate in markets.
So here is financial markets primer that takes a step back from the daily noise:
What Are Financial Markets?
Efficiently functioning financial markets are an essential element of capitalism, a system characterised by private property ownership, competition, ongoing innovation, and the profit motive.
The drive for profits encourages businesses to invest in research, development, and innovation, which can boost productivity and create wealth. Investors who participate in financial markets have an opportunity to share in that wealth.
Not every firm will succeed. But it is this competition that lies at the heart of a market economy. The most efficient and innovative firms are the ones that thrive in the long term, driving overall economic growth and market returns.
Within this system, financial markets channel the required capital to finance these wealth-generating activities by bringing together buyers and sellers to trade financial assets in the form of stocks, bonds, currencies, and commodities.
These markets can be physical places, like the New York Stock Exchange, or digital platforms, such as the NASDAQ. The assets traded represent claims on future cash flows or ownership, and their prices fluctuate based on supply and demand.
There are different types of financial markets, each serving a specific function:
- Stock markets allow investors to buy and sell shares of companies. When you own a stock, you own a piece of the company.
- Bond markets enable the buying and selling of debt securities, where investors lend money to entities (governments or corporations) in exchange for regular interest payments. Hence the name – ‘fixed interest’.
- Commodity markets trade physical goods like oil, gold, and agricultural products. Many of these are priced in US dollars.
- Foreign exchange (forex) markets involve the trading of currencies and are by far the world’s biggest market by turnover.
- Derivatives markets involve contracts – like options and futures – whose value is based on the price of an underlying asset.
The History of Financial Markets
Markets are not a recent phenomenon. In fact, historians have traced references to organised markets – where buyers and sellers met to haggle over prices for specific commodities – as far back as the Middle Ages in Europe.
Centuries later, with the growth of international trade, the development of systems of credit, and the advent of mass production, markets became more sophisticated.
In the 17th century, the arrival of limited liability companies helped finance the growth of mercantilism as Dutch, English and French shipping businesses sought markets in India and further east.
Formal stock exchanges, which brought together stock issuers with buyers and sellers, began to appear in the 18th century, first in London and then in the US. The New York Stock Exchange soon became the world’s biggest and remains so today.
All along, governments – as well as individuals, banks and companies – were major players in financial markets. The growth of globalisation, as well as the fighting of wars and the building of infrastructure such as canals and railways required governments to raise capital via the issuance of bonds – essentially an IOU.
Trade was facilitated by the growth of the foreign exchange markets, initially via a system where individual countries set their currencies to a fixed quality of gold, and then after World War II to the US dollar, and finally to the market-driven floating system we have today for most developed economy currencies.
Alongside bond, equity and currency markets, commodity markets (the oldest markets of them all) accelerated the development of derivative instruments like futures and options, which allowed producers of commodities such as corn or grain to ‘hedge’ or lock in a fixed price for their output.
Today, global financial markets are enormous. According to the US Securities Industry and Financial Markets Association (SIFMA), the global stock market alone, which includes all publicly traded companies around the world, is valued at more than $US115 trillion. The bond market, encompassing government and corporate debt, is even larger, valued at more than $140 trillion.
The largest market by trading volume is the foreign exchange market, where the average daily turnover alone is above $6 trillion.
Participants in financial markets include governments, banks, non-financial companies, institutional investors like super funds, mutual funds, sovereign wealth funds and hedge funds, and of course retail investors.
The Roles of Financial Markets
Financial markets, as we have seen, have been inseparable from the development of the world economy over centuries to the extent that they now play multiple and critical roles for various stakeholders. These functions include:
Allocating capital:
A primary role of financial markets is to allocate capital efficiently. Companies that need money to grow will raise funds by issuing stocks or bonds. Investors provide that capital by purchasing these financial instruments, hoping for future returns. Governments issue bonds in global markets to meet their own commitments beyond what they receive in taxes.
Price Discovery:
Financial markets help establish prices for securities through the forces of supply and demand. For instance, the price of a stock is determined by how much investors are willing to pay for it, based on their expectations of the company’s future earnings. Prices are forever changing based not only on the fortunes of individual companies but on overall risk appetites and the economic environment.
Liquidity:
Markets provide liquidity, which means that assets can be quickly bought or sold without significantly affecting their prices. This is critical for investors who need the flexibility to enter and exit positions efficiently.
Risk Management:
Investors and businesses use financial markets to manage risk. For example, by trading derivatives, businesses can hedge against fluctuations in commodity prices, interest rates, or exchange rates. Exporters can lock in prices for commodities via futures or options contracts.
Facilitating Economic Growth:
By channelling savings into productive investments, financial markets stimulate economic growth. A company that raises capital through the stock market can use those funds to expand operations, hire more employees, and develop new products, ultimately benefiting the overall economy.
Building Wealth:
In participating in financial markets through the investment of their savings, individuals and families can earn a return that fits their financial goals, investing time frames and risk appetites.
What Drives Returns in Financial Markets?
The factors that drive returns in financial markets over the long term are not necessarily the same as the many more short-term influences on return. For individual investors putting their money at risk, understanding that difference can go a long way to ensuring a good outcome.
Long-term returns are driven by a host of factors, including economic growth, corporate earnings, innovation, productivity, technological change, the profit motive and the level of competition among firms.
A complex interplay between these factors is how long-term wealth is created and provides the opportunity for investors of all kinds to share in that wealth.
These drivers need to be distinguished from short-term influences that drive the ups and downs of markets day-to-day. These can include economic indicators, company announcements, regulatory news, geopolitical events and shifts in sentiment.
At a level below the big long-term return drivers mentioned above are specific return components of each asset class. These systemic sources of returns in shares and bonds have been rigorously documented in modern portfolio theory and provide investors with a range of choices according to their goals and risk appetites.
The factors below can be seen as the building blocks of a diversified portfolio:
Equities
- The Equity Premium – Long-term, equities outperform bonds. While bonds offer defence in a portfolio, equities provide growth. Still, there will be times when bonds outperform, which is why you may want both in your portfolio.
- The Size Premium – Small companies outperform large companies over the long term. But the size premium is not positive every year. Your exposure to it will depend on your own goals and risk appetite.
- The Value Premium – Lower relative price, or value, companies outperform higher relative price, or growth, companies over the long term, but as with the other premiums, in any one year or sequence of years value can lag growth.
- The Profitability Premium – More profitable companies outperform less profitable companies over time. This is also known as the Quality Premium.
Fixed Interest
- The Term Premium – Longer duration bonds outperform shorter-duration over time. Again, this does not necessarily happen every year. In some periods, there may be no premium for investing further out than, say, two years.
- The Credit Premium – Lower credit quality bonds outperform higher credit quality over the long term. There can be times, however, when there is little additional return for taking on credit risk. We saw this before the GFC.
Knowing these components of return allows investors to focus on what they can control, like costs, taxes, diversification and their own discipline.
In terms of short-term influences like macro-economic indicators and company earnings announcements, there is little to be gained from second-guessing prices, which adjust instantaneously to new information.
The degree to which each investor is exposed to these long-term premiums, as well as how much they allocate to equities, bonds and cash, will be determined by their individual circumstances, goals and risk preferences.
Summary
After hundreds of years of evolution, global financial markets are now enormous and multifaceted systems that play crucial roles in the functioning of the global economy.
By facilitating the flow of capital, enabling price discovery, providing liquidity, and allowing for risk management, they help businesses grow and individuals invest to meet their long-term goals.
Understanding the long-term drivers of returns and the components of those returns at the level of each asset class can help investors navigate these markets and make informed decisions. This is best done with the support of a professional and independent financial adviser.
Though financial markets can be volatile at times, they remain an essential pillar of the world’s economic framework. And with knowledge of their workings, investors can better position themselves to take advantage of the opportunities they offer.
