Understanding global markets
The word “global markets” is rather self-explanatory as there are places where buyers and sellers meet and transact. Yet, by its diversity and sheer volume, markets can be confusing to outsiders. Each one has its own function and participants have different needs to fulfil. Financial institutions, corporates, governments, asset managers and hedge funds are major players in the field and each expresses their view of the state of the market. High net worth and retail individual are also part of the game.
Asset classes and functions
Capital markets include the equity (stock) market and debt (bond) market. Both are used to provide and manage liquidity for companies, governments, and individuals. Institutions access capital markets to raise capital for long-term purposes, or for other capital projects. In the bond market, companies and governments may issue debts in the form of corporate or government bonds respectively.
Commodity markets are physical or virtual marketplaces for buying, selling and trading raw or primary products. Futures contracts allow companies to offset their risks by locking in the price of their future transactions. Investors trade in these markets to speculate on price movements. The most active commodity markets include oil and gold markets.
The currency market is by far the largest of all by volume with more than $5.3 trillion traded every day, and 87 percent involves the US dollar. Currency trading is decentralized and dominated by the need to reduce the impact of exchange rates and the uncertainty of doing business overseas. The inherent volatility of the FX market can offer opportunities for speculators like hedge funds and individual investors.
Market dynamics are forces which will influence supply and demand and ultimately impact prices and the behaviours of participants. Besides classical interpretation of price, demand, and supply, emotions can also drive decisions and weigh substantially on asset volatility.
Fundamental factors are qualitative and quantitative information that contributes to the financial or economic well-being of an asset, be it a company, security or currency. They are a key foundation to the price discovery. Macroeconomic (including unemployment, supply and demand, growth, and inflation, monetary and fiscal policy and international trade) and microeconomic fundamentals (factors within a particular market or sector) tend to drive markets over the medium to long-term.
Technical factors are the mix of external conditions that alter the supply of and demand. Most important of them are price volatility, trends and liquidity. The existence of trends can help an asset gather more momentum and move by what some would call “self-fulfilling prophecy”. The oil rally in the first part of 2019 can attribute to the establishment of an uptrend.
Market sentiment refers to the psychology of market participants, individually and collectively. Sentiment is subjective, biased, and obstinate by nature. The human factor creates an unpredictable and difficult-to-quantify effect that always results in increased volatility.
Risks & Opportunities
Trading the markets comes with risks and rewards. Whether it is for the purpose of hedging unwanted exposures or of building investments, sound understanding and management of risk factors are paramount to achieving desired financial goals.
Systemic risk is the possibility that an event at the asset level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called “too big to fail.” In the currency market, major central bank action could sink a currency in a matter of seconds. Fortunately, systemic risk can be mitigated through diversification by holding uncorrelated assets.
Systematic risk also known as market risk is the risk inherent to the entire market. This type of risk is both unpredictable and impossible to completely avoid. Shifts in interest rate, inflation, recessions and political events, among other major changes can affect global markets and cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.
Liquidity risk refers to the impact that buying or selling an asset or security in the market has on its price. Those assets that cannot be readily bought or sold at prevailing market prices due to structure, valuation uncertainty, complexity, uniqueness, or size are considered illiquid. Bonds, oil or major currencies markets are liquid enough to have the capacity in absorbing large transactions without significantly impacting the price.
With risk comes opportunity. Diversification as aforementioned is a proven way to reduce volatility in business or financial portfolio. Safe haven assets like gold, the Swiss Franc or the Japanese yen can serve as hedging tools along correlated or riskier assets e.g. stocks, real estate, or commodities.
Understanding what markets do and what makes them tilt is the first and necessary step before putting one’s skin in the game. Opportunities only shine when risks are properly managed. If done right, a balanced portfolio can smooth out volatility and yield superior risk-adjusted returns. Under normal economic and market conditions, riskier assets would produce higher returns. In times of uncertainty, conservative or income-generating assets can cushion market swings and shield the portfolio from rapid depreciation.