By FERNANDO NOGUEIRA DA COSTA*
Investor expectations are affected by the causal relationships between exchange rate, inflation rate, interest rate, growth rate and unemployment rate, which are complex and interdependent.
The predominance of either value investors or trend-following speculators in the stock market influences financial leverage and deleveraging cycles. These two types of participants have different approaches and behaviors, affecting the dynamics of this capital market and credit or debt cycles in different ways.
Value investors base their investment decisions on fundamental analysis typical of economists, seeking to buy shares considered undervalued in relation to the companies' economic fundamentals, such as profit, cash flow and assets. They tend to maintain these positions for the long term, waiting for the Market (being supernatural because it is omnipresent, omniscient and omnipotent) to correct any undervaluations.
When these value investors predominate, the stock market tends to be more stable because they do not engage in rapid buying and selling based on short-term fluctuations. The preference for observing microeconomic, sectoral and macroeconomic fundamentals, on certain occasions, results in lower financial leverage, because they seek sustainable and consistent returns, rather than quick wins.
During periods in which value investors predominate, deleveraging tends to occur in a more gradual and orderly manner, driven by assessments of asset prices being elevated relative to fundamentals. This behavior helps to cushion shocks and avoid financial bubbles.
Differently, trend-following speculators [trend followers] make decisions based on price trends and market momentum, using technical or graphical analysis typical of “econophysicists”. They buy rising assets and sell falling ones, hoping to profit from these trends continuing.
When speculators predominate, markets become more volatile. Purchases and sales are fast and reactive, even carried out by algorithms. They use leverage to amplify their returns, increasing the risk of asset bubbles during bull cycles and sharp corrections during bear cycles.
The predominance of speculators usually leads to more intense leverage cycles. When trends are bullish, speculators leverage their positions to maximize gains, inflating asset bubbles. However, these bubbles inflate and explode. Turns in the bearish trend lead to rapid and disorderly deleveraging, exacerbating financial crises.
Therefore, both impact the leveraging and deleveraging cycles. During high cycles [Bull Markets], the dominance of trend-following speculators leads to a rapid expansion of leverage as more participants seek to profit from rising asset prices. This generates a self-feeding cycle of appreciation and greater leverage.
Down cycles [Bear Markets] occur when the market index (Ibovespa, Dow Jones, S&P 500, Nasdaq, etc.) begins to correct or reverse the trend and speculators quickly seek to reduce their leveraged positions. It triggers mass sales, precisely because they have gone into debt.
This accelerated deleveraging aggravates price drops, leading to liquidity crises and amplified effects on the financial system, favorable to those who made “short sales”. They borrowed money to rent shares, sell them high and repurchase them low to return them with the profit pocketed.
The dominance of value investors during periods of market correction helps smooth the deleveraging process. These investors, by seeking out undervalued assets, provide support to asset prices and help stabilize the market, preventing steeper declines and financial disarray.
The transition between the predominance of one or the other leads to changes in market regimes, alternating periods dominated by each one. These transitions are usually influenced by changes in economic conditions, monetary policies, or external events capable of altering market expectations.
After a financial crisis, value investors often predominate, focusing on microeconomic, sectoral, macroeconomic fundamentals and long-term opportunities. As the stock market recovers and confidence returns, speculators become more active, seeking to profit from the emerging trend, leading to a new phase of financial leverage.
Critics of “financialization” should understand this logic of the capitalist market economy, for better interpretation, instead of just condemning it. The predominance of value investors tends to favor more moderate and stable leveraging and deleveraging cycles, while the predominance of trend-following speculators leads to more extreme and volatile cycles.
The dynamics between these groups of market participants play a crucial role in the formation and bursting of asset bubbles (forms of wealth maintenance), as well as the stability of the financial system as a whole. Wealth in financial assets represents 54% of the world's wealth and the majority is quoted in shares. The exchange rate is decisive in determining its global purchasing power.
Therefore, investor expectations are affected by the causal relationships between exchange rate, inflation rate, interest rate, growth rate and unemployment rate, which are complex and interdependent. These variables interact dynamically, influencing each other.
The rise in the exchange rate (depreciation of the national currency) increases the price of imported goods and services. If it generates inflationary pressures, it is a phenomenon known as “imported inflation”. In the case of the Brazilian economy, for example, the high dependence on imported inputs and products amplifies this effect. Sudden movements in the exchange rate alter inflation expectations, leading economic agents to adjust prices preventively.
An increase in the domestic interest rate attracts foreign capital, valuing the local currency, that is, appreciating the real. Investors seek higher returns in fixed income with higher interest rates, increasing demand for the Brazilian currency.
However, higher interest rates slow economic growth and, in the long term, this weakens the currency, due to capital flight due to the expectation of lower returns in the future. The Central Bank of Brazil uses the interest rate (Selic) as the main instrument for controlling inflation. By increasing the interest rate, it seeks to reduce aggregate demand to contain inflation. Higher interest rates make credit more expensive, reducing consumption and investment.
The interest rate directly affects the cost of capital. When it is high, the cost of capital is also high, discouraging private investment and, consequently, negatively impacting economic growth.
In general, there is an inverse relationship between economic growth and unemployment. Growth tends to reduce unemployment, because more labor is needed to sustain the expansion of production. If economic growth is insufficient or negative, unemployment tends to increase.
The traditionally observed relationship between unemployment and inflation suggests an inverse relationship between the two variables. In low unemployment scenarios, inflationary pressures arise due to increases in wages and aggregate demand. However, this relationship is not static and changes in different contexts.
A higher exchange rate makes Brazilian exports more competitive, contributing to economic growth. However, the cost of imported inputs increases, negatively impacting the production sector. Movements in the exchange rate consequently affect the economic cycle, with excessive appreciations leading to competitiveness crises and depreciations leading to price instability.
These relationships are influenced by several factors, such as fiscal policy, the global situation, the credibility of the Central Bank, exogenous shocks such as variations in commodity prices and international crises, etc.
In the Brazilian economy, these dynamics interact with structural and cyclical issues specific to the country. Understanding these interactions requires a systemic approach to take into account not only the economic variables themselves, but also the expectations of economic agents and the institutional and international context in which they are inserted. Financial life is complex, critics of “financialization” need to learn how to deal with it…
*Fernando Nogueira da Costa He is a full professor at the Institute of Economics at Unicamp. Author, among other books, of Brazil of banks (EDUSP). [https://amzn.to/4dvKtBb]
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