The Risk of not seeing the Forest for the Trees
When the media or the general public refers to “the market”, it is predominantly fixated on the stock market. I suppose individual companies and their strategies are more exciting to discuss than the grain supply in Iowa or the Mexican peso. Many times throughout my career I have been approached with the question of why I chose to concentrate on the currency market when the “real” market is clearly equities? The simple answer is that FX constitutes the biggest and most liquid market in the world and therefore involves any monetary transaction that happens across borders. Look at your smart phone for a second and consider the various components’ geographic origins and you will realize that in order to put that phone together it probably took many currency trades between the manufacturers, shippers, marketers and sellers of this phone. The same can be said of most items we possess these days.
The global market
Let us take a look at the size of the various financial markets in the world. First, consider daily volume below:
As you can see, the size of currency traded daily is about 25 times the size of global equity markets. Missing in the chart but added for obvious reasons is the global bond market that has an approximate $2 trillion a day volume. which also dwarfs the stock market. As currency is practically speaking zero coupon debt with no maturity, the size of the global currency/debt market combined makes up 95% of daily volume in the financial markets while the remaining 5% are reserved for stocks. Having said that, a good part of the bond and fx markets revolve around global public companies that need to engage in these markets to mitigate risk or transfer productivity. Also, buying foreign equities entails a currency transaction, directly on a foreign exchange and indirectly via ADRs.(foreign shares traded at home in domestic currency). However, we hear very little about the effectiveness of multinationals in managing their fx risk, something share holders should and serious ones do consider.
Total size of the global capital market
Now that we have established the market share of each asset class on a daily volume basis, let us examine the total size of the global capital market next.
While this chart is somewhat dated, you can clearly see that the outstanding tradable debt in the world far exceeds the existing market capitalization for global equities. Evidently, the bond markets of the world should be given more attention by the any market participant who thinks of “the market” as the stock market.
Back to the Forest
The point of this blog is to show readers who are fixated on the stock market that in reality, the major monetary flows occur via currencies and in bonds. Now ask yourself where the potential financial problems exist in today’s world? Overall, corporate balance sheets look rather healthy but it is the public debt and the bloated central bank balance sheets that carry most of the outstanding risk. In other words, when the next economic down turn reaches the “core”, we will likely notice it first in the currency and bond markets as we do today in the emerging markets. Considering the size of these markets you may wonder how big the ramifications will be which is unknowable at this point beyond the fact that they probably will be very substantial. As for stocks, we may at first find ourselves in a rapidly rising stock market in blue chips once Treasuries sell off and currencies devalue. Money will likely continue to move out of cash and bonds and look for tangible assets such as stocks, commodities and (unlevered) real estate, driving those prices higher, aka stagflation. In the meantime, I would recommend sharpening up on your fx skills where large movement is likely to emerge in the coming years. Finding the right currencies to be in may be an effective way to hedge your portfolio regardless of stocks and bonds.
For those of you who would like to learn more about the currency market, below are some interesting charts regarding composition, turnover, market participants and location of this particular market.