Global
What Happens When We All Get More Pessimistic and Think There Is More Risk?
March 08, 2007

By David Miles | London

That sounds like a dumb title, or at least a title that poses a question with a blindingly obvious answer: risky assets fall in price and safe assets (e.g., inflation-proof government bonds) get to be worth more. And because nearly everyone thinks it is a blindingly obvious answer, it seems a perfectly satisfactory ‘explanation’ for what has happened in stock and bond markets for much of the past two weeks. Equities have fallen quite a lot pretty much everywhere across the world — though with a bit of a bounce in recent days; and government bonds have rallied. The reason? Overwhelmingly the favourite answer is: a combination of a bit more pessimism about economic fundamentals and a lot more worrying about risk.

Maybe that is right. I don’t know. But as a bit of logic it is actually not particularly compelling. Here’s why. Suppose people become a bit more gloomy about average growth in incomes (and in GDP) and also think the risks are greater — the volatility in the path of future output is bigger than we thought just a short while ago. What do we think might happen? Lower growth in future incomes and greater uncertainty about those incomes have an impact on how much people need to get as a return on a safe asset — they both lower it. More uncertainty means people pay more for the re-assurance of holding an asset with a known return. And lower likely growth in incomes and future consumption means you are more inclined to transfer some spending power into future consumption by saving. So, for both reasons, the real yield on safe assets goes down. I don’t know of any coherent economic model that does not have that property.

What about the price of a risky asset, like equities? Stock prices should reflect the path of the future income that they generate — and on the whole that will be linked to productivity growth and hence growth in GDP — and also depend on the required return. The required return can be thought of as the safe real rate plus a risk premium.

When we get more pessimistic about future growth and also think risks in future incomes are greater, several different things happen to the pricing of risky assets.

First, we get a fall in the safe real rate of return — that is a positive for the value of all financial assets.

Second, if we are more pessimistic on growth, the likely increase in corporate earnings is lower — this is a negative for stocks.

Third, with more variability in future income, the equity risk premium will probably go up — a negative for stocks.

 

What about the relative size of the different effects? To say something about that, we need a model of risk, risk aversion and growth. In What Should Equities and Bonds Be Worth in a Risky World, David Miles, Vladimir Pillonca and Melanie Baker, September 12, 2005, we used a model proposed by Robert Barro of Harvard (Rare Events and the Equity Risk Premium, NBER Discussion paper 11310. May 2005) to assess how risk aversion, growth and volatility combine to generate asset returns. Using that model — which is pretty standard in economics — it turns out that the reduction in the safe real rate of interest that comes about from a fall in expected future growth very likely has a bigger positive impact on equity prices than the negative effect of the lower likely growth in future corporate incomes.

It may be helpful to just illustrate that result with one simple equation:

A standard bit of simple economics says that stock prices should reflect the current and expected future levels of corporate earnings, which let’s assume grow on average by rate g, discounted by a rate that is the required return on equities. That required return is the safe real rate (r) plus an equity risk premium (erp). Putting this all together gets a familiar formula for the link between the stock price, P, and today’s corporate earnings, E:

P = E / (r + erp -g)

Suppose we get more pessimistic about productivity growth, so g falls. This affects r. In fact, if r falls by more than g, stock prices go up. And most plausible estimates of the link between a safe real interest rate and the growth of future incomes and consumption would suggest that r should move more than g — in other words, if likely future average growth falls permanently from 3.0% to 2.5%, the safe real rate could be expected to fall by more than 50bp.

What about risk, as measured by the perceived volatility of future growth of output? Say perceptions of risks about future output change. Again this has two effects which, as regards the price of equity, go in opposite directions. First, the equity risk premium should go up — and this reduces stock prices. But more risk means that the safe real interest rate should fall — and in itself that is positive for stock prices. The equation above shows the two-way pull of the impact of more volatility, or risk: r is lower and erp is higher.

So which of these effects is stronger? We find that for plausible assumptions about the structure of economies and people’s risk preferences, it is quite plausible for the safe real rate to fall more than the equity risk premium rises. So, more volatility in future incomes would be mildly positive for stock prices rather than substantially negative.

What all this means is that a pretty standard economic model can generate the prediction that more pessimism about average future growth and greater uncertainty about future growth will take stock prices a bit higher.

All this may seem largely academic and of little value to practical people who have to make money in financial markets. It may remind some of the old joke made at the expense of the head-in-the-clouds academic who on seeing some real world phenomenon observed that it was all very well in practice but it shouldn’t work in theory.

On the other hand, we might just stop and wonder a bit whether what appears to be a nice logical ‘explanation’ for falls in stock prices — like ‘people got worried about risk and more pessimistic about growth’ — really does explain very much at all about what just happened.

 

Tunisia
Calling for a Job
March 08, 2007

By Serhan Cevik | Boston

Macro discipline and call centers are not enough for employment growth. Out of 54 countries in Africa, only three (or four, according to Moody’s) enjoy the rating status of investment grade: Botswana, South Africa, Tunisia and Mauritius. Although some are surprised by Tunisia’s credit rating, there is really nothing surprising, in our view, and it probably deserves an upgrade as well, with its sound fiscal stance and debt dynamics. The country’s budget deficit narrowed from a peak of 7.6% of GDP in 1997 to an average of 3.1% in the last six years, helping to lower the stock of government debt from 62.5% of GDP in 1997 to 59.5% last year. With the easing fiscal burden, the Tunisian economy has experienced a marked acceleration in growth from 1.7% in 2002 to an average of 5.3% in the past four years. Unfortunately, maintaining macroeconomic discipline is not always sufficient to speed up job growth and improve income distribution, especially when more and more countries adopt a similar set of prudent policies. Likewise, call centers servicing the European clientele will never be able to create enough jobs. This is why Tunisia must now look beyond macro into micro to deal with demographic pressures and take the economy to the next stage of development.

Despite strong growth, the unemployment rate showed a small improvement. Real GDP growth has run at an average of 5.1% in the last ten years, which is, by any standard, a robust pace of output growth. Nevertheless, it has still failed to accelerate employment growth to a rate that is significantly above the increase in working-age population. As a result, the unemployment rate showed a sustained but small improvement from 15.4% of the civilian population in 2002 to 13.9% last year. There are, of course, exogenous factors (such as the removal of quotas on textiles and clothing) that have limited employment growth in Tunisia, where the textile sector still accounts for no less than 40% of exports. However, it would be a mistake to neglect structural bottlenecks lowering the employment intensity of growth, especially at a time when the whole world (including Tunisian companies) focuses on how to improve productivity.

Services are becoming the leading engine of employment growth in Tunisia. From a macro point of view, the rate of employment growth may be inadequate, but structural shifts in the labor market are encouraging. Changes within industrial sectors towards higher value-added businesses, though playing a limited role in job growth, have made a significant contribution to income generation. However, service sectors — accounting for 20% of GDP — are now growing almost twice as fast as the rest of the economy and thereby becoming the leading engine of employment growth. And with a well-educated workforce, Tunisia can accelerate the current momentum in services and move upward in the global outsourcing ladder. Thanks to strong linguistic skills at lower wages, call centers servicing mainly French customers at this stage have already employed an increasing number of job seekers. However, as India’s experience has shown, Tunisia cannot rely on call centers (or similar endeavors) to create enough jobs for the steady flow of 80,000 new graduates every year, even if we ignore already unemployed workers.

Increasing private investment and improving labor market flexibility are key. Macroeconomic stability is the most important building block for a business climate that is conducive to private investment and sustainable employment growth. Tunisia’s own experience with macro discipline and liberalization is the best possible case in point. The increase in foreign direct investment, for example, led to 260,000 new jobs in a variety of sectors over the course of the last decade. But the economy now needs additional reforms addressing structural weaknesses at the micro level to achieve greater integration with the global economy and to accelerate job creation. Our calculations suggest that reducing the unemployment rate by four percentage points to just below 10% in the next five years would require annual real GDP growth of 7% and an increase of approximately 8.5 percentage points of GDP in fixed investment expenditures in the private sector. It is certainly challenging, but not impossible, as long as the authorities eliminate rigidities in the labor market and keep improving the quality of education.

Philippines
Rates on Hold
March 08, 2007

By Deyi Tan and Chetan Ahya and Tanvee Gupta | Singapore, Mumbai, Mumbai

Maintaining the status quo: The central bank (BSP) left the monetary policy unchanged, with the overnight lending rate at 9.75% and the overnight borrowing rate at 7.5%. The tiering system (7.5% for placements under PHP 5 billion, 5.5% for placements in excess of PHP 5 billion and 3.5% for placements in excess of PHP 10 billion) on bank placements with the central bank is also maintained.

Inflation remained benign: February inflation numbers continue to decelerate further from January’s 3.9% to 2.6% YoY on the back of base effects from the implementation to the Reformed Value-Added Tax in February last year and a stronger peso.  Specifically, food inflation fell to 3.0% YoY (versus +4.3% YoY in January). Utilities prices rose 1.5% YoY and services 2.4% YoY (versus +4.7% and 3.7% in January, respectively).

Short rates stayed at levels near the lowest-tier overnight borrowing rate amid excess liquidity: The 91-day Treasury bill yields have backed up by 30bp or so since the market correction we saw last week. However, yields continued to hover close to the lowest tier of the overnight borrowing rate, at about 3.6%, implying that the effective policy rate is likely at the lower range of the tiering system. This is an indication of the abundant liquidity in the system. The latest weekly data show the stock of excess liquidity (reverse repurchase agreements) continuing to rise to US$5.6 billion as of mid-February.

Credit growth cycle underway: The latest loans data showed a continued acceleration in loan growth to 10.0% YoY (3MMA) in December from 8.6% in November. We reiterate our case that a sharp decline in the cost of capital will likely bring about a credit growth cycle over the next 12 months to 15-18% YoY.