The market and the economy in 2011

For investors there is always something to worry about. The past year was no exception to this rule.

Clearly, the unmanageable Greek sovereign debt must be at the forefront of our minds, since it has repeatedly been the cause of unrest in the market. At times, attention was also focused on Portuguese, Spanish and Italian debt, which is potentially even more serious. To cap it all, US politicians, whose sovereign debt has always enjoyed a triple-A rating, succeeded in discussing themselves into a downgrade by Standard & Poor’s.

There are two dimensions to the fear and unrest felt by investors. Firstly, it is clear that for many countries, and for many years to come, tight fiscal policy will be the order of the day, both out of fiscal necessity and because this represents the dominant political consensus. Pro-cyclical belt-tightening is rarely a suitable means of promoting healthy growth.

Secondly, there is concern that high unemployment and social unrest will feed a more fundamental pessimism and fear of investment that will turn Europe – and perhaps the West more generally – into an economic backwater. From this perspective, the economic significance of, for example, riots in the UK is greater than can be read from the direct damage caused.

Social unrest is closely linked to fiscal policy and economic growth. Research has shown that when budgets are tightened or when growth rates shrink, the incidence of riots and demonstrations increases. This serves to emphasise the more fundamental anxiety underlying last year’s poor market performance: the fear that large parts of the West are facing a downward economic spiral.

Thus, in purely financial terms, the earthquake disaster in Japan was of less significance, notwithstanding the enormous direct damage and tragic deaths that ensued. What has been lacking is a belief in the future.

This is probably the most likely explanation for the drop in the MSCI World Index by over 5.0 per cent (adjusted for dividends) and the downturn of almost 12.5 per cent in the Norwegian benchmark index, despite very satisfactory earnings. This also explains why investors flocked to short-term government papers in countries that were presumed to be safe, while the risk premiums climbed in the case of other sovereign and corporate debt in general.

Accordingly, both the stock market and the credit market tell us the same story: 2011 was a year in which the cost of capital was high, and rising.