Are financial markets a reflection of the economy and its business cycles or vice-versa? The accounts of most mainstream economic textbooks and academics would suggest that financial markets are considered an approximation of real economic activity, and have little significance in models that interpret and predict business fluctuations.

It is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. The  financial sector is first and foremost perceived as an intermediary that allocates capital efficiently between savers and borrowers. Low rates, should increase the demand for loanable funds for investments and consumption thus leading to future economic growth. An increase in bank lending and monetary aggregates following a recession are thus interpreted as a sign of  recovery.

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An interesting Societe Generale research report1 contradicts this popular notion and shows that although companies are currently cash rich they are issuing debt at record rates and offsetting this with an equal measure of equity buy-backs, thus leveraging their capital structure as seen in the chart below.

Bildschirmfoto 2012-12-12 um 18.45.24The report therefore suggest that the increase in bank lending and monetary aggregates, traditionally a signal of recovery following a recession should be viewed with caution as it implies more risk-taking and not necessarily a solid recovery.


The following chart shows a similar picture graphing the average asset age, which in recent years spiked significantly upwards. This spike further exemplifies that instead of spending on CAPEX, companies have been using their cash for other purposes.

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While the explanations above are coherent and plausible, the financial markets themselves offer similar viable interpretation.

Similar to Plato’s allegory of the cave, where we are reminded that we are like prisoners and assume the shadows on the wall in front of us to be to be the real world, each argument has two sides. Contrary to the implications of most textbooks it is difficult to judge whether the shadows we see are reflections of the real economy or whether of the real world activity is influenced by precisely those shadows it is supposed to be creating.

As such, perhaps the answer for buy-backs can be found in the equity market themselves.  This new paradigm of record low interest-rate yields forces investors to look for income elsewhere. Therefore companies which pay-out solid cash via dividends or buy-backs are rewarded by the market. The following two charts show personal interest and dividend income for the US. As mentioned low levels of rates have decreased interest income while income-seeking investors piling in to dividend paying stocks have contributed to a sharp increase in dividend income.

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Finally, one can draw differing conclusion using precisily the same data from above, namely the increase in monetary aggregates M1 and M2, which are interpreted as a sign of recovery. However only a fraction of the modern monetary system falls within the realm of the regulated system. Viewing the system holistically, the de-leveraging of the shadow banking system (unregulated yet vital in liquidity and maturity transformation) becomes apparent and was the single most deflationary effect of the  broader financial system.  Courtesy of zerohedge the following chart shows that on a blended notional basis, total traditional and shadow liabilities have not significantly moved over the last three years despite the massive injections from the Fed (main increase in M1 quantity)

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As such the last graph shows that the premises from the beginning about an improvement in monetary aggregates (M1 and M2) is flawed on its own as the increase in the traditional bank liabilities have merely offset the de-leveraging of the shadow-bank system. It remains vital to view a variety of different data to not be fooled by the shadow the financial markets throws on the real economy.


1 https://www.sgresearch.com/