Last Updated on April 29, 2025
Overview – The Interesting Relationship Between the Economy and Financial Markets
Whenever the economy or financial markets are discussed, it’s not uncommon to hear one of these things being discussed along with the other. After all, many people understand that the economy and financial markets are related.
However, the big questions are to what extent does this relationship go, and is this relationship as direct as many people make it out to be?
While many people, including investors, have a rough idea of what the “economy” and “financial markets” are, their understanding of how exactly these two entities relate to one another is even more nebulous.
In this article, we will explore how exactly these two entities are related and why investors need to keep this relationship in mind.
What Exactly Do We Mean by “The Economy”?
Most people are familiar with “the economy” in a vague, general sense, but come up short when it comes to the specifics. So, what exactly does it encompass, and to what extent should investors care?
Without going into an in-depth discussion, economics is all about how to best allocate limited resources, and is commonly split into two main branches: macroeconomics and microeconomics.
Macroeconomics, as the name suggests, is concerned with economic concepts and theories on a large scale, which usually means at the national or global level. Concepts such as aggregate supply, aggregate demand, gross domestic product (GDP), employment data, inflation, and monetary/fiscal policy are discussed at the macroeconomic level.
On the other hand, microeconomics is primarily concerned with the economic activity of individual, non-national entities such as businesses (large and small), families, and individuals. Additionally, microeconomics seeks to understand what influences the decisions made by these entities.
In the context of our discussion, the definition of “the economy” that most investors will adhere to will likely be a combination of both macroeconomics and microeconomics.
Most investors will care about the “big” economic picture, such as GDP growth, employment data, inflation, and policy, but they will also care about individual industries/sectors, businesses, and overall consumer sentiment.
Of course, the specific concept of “the economy” will vary between investors, but it likely won’t vary that much.
What Do We Mean by “Financial Markets”?
Like the economy, most people, including investors, have a general idea of what “financial markets” are but fail to create a more comprehensive definition.
When talking about financial markets, many people immediately think of the stock market, and while that is correct, it’s only partially so. The stock market represents one of many other financial markets. There are also bond, option, derivative, currency, and cryptocurrency markets, all of which trade financial products/instruments.
Therefore, we can think of “financial markets” as an umbrella term that covers any market/exchange that enables buyers and sellers to trade financial products/instruments.
Despite this broad coverage, most investors will likely get involved with only a few markets/exchanges during their careers.
Why the Connection Between the Economy and Financial Markets Isn’t Straightforward
Many people and investors alike believe that the economy and financial markets are just two sides of the same coin, with some going as far as conflating the two concepts.
Is this conflation more or less accurate, or is there more to this relationship than meets the eye?
First, let’s study how the economy and financial markets are related, or, more accurately, how people think they’re related. The logic usually goes that whatever happens in one domain will inevitably “spill over” to the other because of their inherent interconnectedness.
For example, imagine the economy of a country has, in recent years, been doing very well. GDP growth is strong, unemployment is low, and consumer confidence is high. The belief is that this economic strength means businesses, most notably publicly-traded corporations, will post strong financial performance and/or expand their operations, compelling investors to deploy their capital in these strong enterprises, thereby lifting financial markets such as equity and bond markets.
The reverse case is also assumed to be true: when financial markets in a given country are strong, usually indicated by select market indices, this is taken as a sign of a strong economy. One of the prevailing assumptions is that if publicly traded companies are experiencing record growth, then surely this means the economy as a whole is also doing well.
For the most part, this relationship between the two is more or less valid, but only to an extent, because some major problems exist.
First, despite their apparent similarity, the economy and financial markets represent two very different things. The economy is, in very simple terms, an overall measure of productive output and consumer activity. Financial markets are places where people exchange products that are governed by the forces of supply and demand.
Financial markets tend to rise (or fall) whenever economic data is reported, not because of some highly technical, quantitative relationship, but because buyers and sellers are influenced by this news, creating a sense of optimism (or pessimism) that drives financial asset prices.
Put another way, the relationship between the economy and financial markets is an implicit one at best.
This leads us to our second problem: despite being governed by supply and demand, financial markets are dominated by their participants’ emotions. Just because the economy depicts one reality does not mean financial markets will always accept it. Conversely, financial markets can appear artificially strong due to uncontained investor hype, even if underlying economic data suggests otherwise.
Therefore, there is a relationship, albeit a bit loose, between the economy and financial markets, but it is not as direct or robust as some people make it out to be.
Strength (Or Weakness) in One Can Reflect in the Other, but Not Always
Although the economy and financial markets have a relatively loose relationship, this isn’t to say it has no merits.
Throughout financial history, there’s no denying that whatever goes on in one domain will almost always affect the other. Weaker-than-expected economic data usually means suppressed business activity, leading to a slump in financial markets. Strong financial markets, especially over the long term, are typically indicative of robust, underlying economic fundamentals.
While this has been observed repeatedly in the past, it’s important not to think this is the norm, which will only lead to confirmation bias. There have been times when strength (or weakness) in one didn’t accurately reflect in the other.
At the start of the COVID pandemic, dozens of countries around the world quickly implemented lockdowns, leading to major economic repercussions such as a sharp increase in unemployment rates, shattered consumer confidence, and steep declines in GDP.
While financial markets also sharply declined following the lockdowns, there were several instances when they suddenly shot up, such as when new vaccine developments were reported or the release of better-than-expected employment data. These bouts of market positivity stood in contrast with the grim economic reality going on around the world.
Early in US President Donald Trump’s second term, he announced sweeping reciprocal tariffs on several countries around the world. The possibility that these tariffs would induce a severe global recession was enough to cripple financial markets when they were announced. After these reciprocal tariffs were temporarily paused, markets wasted no time in going back up.
Although these tariffs rattled global markets, the reaction was based solely on what could happen. The reciprocal tariffs weren’t in place long enough for the expected, detrimental economic effects to materialize – the markets simply got ahead of themselves.
So, although the economy and financial markets can sometimes reflect one another, there are notable exceptions to this rule. Assuming that one is always strongly correlated to the other can be fatal.
Why This is Important for Investors
When searching for potential investment opportunities, especially in other countries, investors want to make this process go as quickly as possible. One of the ways to do that is by looking at a country’s economic situation and taking that as a sign of potential investment opportunities waiting to be uncovered.
For example, some investors choose to focus on frontier and/or emerging markets, which are developing economies experiencing rapid growth. The hope is that these fast-growing economies are home to potential investment gems that will also experience the same rapid growth in lockstep with the broader economy.
While this sounds good in theory, it’s not guaranteed that a rapidly growing economy will also be home to an abundance of undiscovered, rapidly growing investment opportunities.
Conversely, investors may prematurely overlook certain countries due to an apparent lack of economic progress. While poor economic development can certainly be a red flag, this doesn’t mean no investment opportunities are waiting to be discovered – they may just be harder to find.
Many investors understand the relationship between the economy and financial markets, but it’s important for them to remember the limitations of this relationship and that it is by no means foolproof.
Wrapping Up
The economy and financial markets are often discussed together, yet the exact relationship between the two isn’t always well understood.
For many people, the logic usually goes that whatever goes on in one will inevitably affect the other due to an inherent connection between them. Economic strength is usually taken as a sign of robust financial markets, and strong markets are taken as an indicator of a strong economy.
While this relationship has been observed before to varying extents, it has merit, but not without its faults. There have been times when developments in one domain aren’t always reflected in the other.
Investors who wish to expand their investment horizons, particularly in different countries, would be wise to keep this relationship and its limitations in mind. Just because a given country reports strong economic growth doesn’t automatically mean an abundance of investment opportunities await, nor does a weak economy necessarily mean an absence of them.
