Measuring the Impact of Equity Shocks on the Economy
March 13, 2007
By Vladimir Pillonca | London
Global equity markets are currently undergoing a correction, and despite the recent respite, there is still uncertainty regarding the likely intensity and duration of this adjustment process. Could the recent falls in equity market indices cause a sharp economic slowdown?
To answer this question, we compare the impact of equity price shocks on the Italian and euro area economies, and discuss the potential scale and duration of the impact, based on historical data (for details see: Equity Shocks and the Impact on the Economy. How Much Should We Worry? March 8, 2007). In theory, the path of households’ consumption depends on their expected streams of labour income and wealth (both financial and housing). The impact of falls in asset prices should mostly be felt on consumption, via negative wealth effects. There is an additional channel from financial markets to economic growth, as changes in asset prices are also likely to affect the willingness to invest, by changing the cost of capital. Most existing (empirical) analyses focus on working out the impact of changes in financial market wealth on consumption. Such evidence suggests that consumption is not that sensitive to changes in equity prices, while it is a little more sensitive to changes in house prices. However, many of these estimates are for the US economy, which differs in terms of the size of its stock market from Europe, and Italy in particular. Eric Chaney and David Miles recently discussed some potential effects of a drop in equities and Chinese growth across Europe (see Testing the Region’s Resilience to Real and Financial Shocks, March 1, 2007). Here we focus on estimating how big the impact on the economy might be and simulate how the shocks might propagate. European stock markets are generally quite small relative to the size of the economy. Italy and Germany are cases in point. The size of the US market is over 108% of GDP, while Italy only breached the 50% mark last year, as did Germany. In Europe, among the big economies only the UK exceeds the US in terms of market capitalisation relative to GDP. A second point is that the ownership of risky securities is concentrated in the hands of a relatively small subset of Italian households, predominantly high earners with a relatively low propensity to consume out of current income. The wealth of Italian households is predominantly housing-related (home ownership is very high, even by European standards). In principle, all of this suggests that the impact of a 10% shock to stock prices on overall GDP should be smaller than an equivalent shock to consumption. But given that consumption is the biggest component of GDP, the impact is unlikely to be zero. Consumption accounts for at least 60% of GDP in advanced economies, Italy included. What comes first? Before we turn to the scenarios, we run tests to determine how GDP growth and equity prices affect each other. Specifically, we test two hypotheses: Do equity prices lead/anticipate GDP growth? Or does GDP growth lead/anticipate equity prices? This distinction is crucial, not academic. If it is GDP growth that precedes (or anticipates) movements in equity prices, then the impact of a drop in stock prices on the economy should be limited. This result holds even if we account for some moderate feedback effects. But if the direction runs the other way around — from equity prices to economic activity — then the implications are more serious, and we should be more concerned about spillovers to the real economy. Besides, feedback effects could propagate the shock further, triggering a negative spiral between asset prices and the real economy. We find that changes in equity prices do not shape the path of GDP growth by a statistically significant degree, while the reverse is true (we test these hypotheses via Granger-Causality Tests). Specifically, past changes in GDP do help to predict movements in equity prices. Finally, to carry out the simulations, we first estimate the linkages between economic and financial variables in Italy and in the euro area, by estimating a set of simple statistical models (Vector Autoregressive Representations, or VARs). The variables of our chosen (VAR) models include current and past changes in the stock market MSCI price index, GDP growth and the steepness of the Italian yield curve. Once that’s done, we simply subject the MSCI stock price index to a one-off negative shock, and let the shock play out until its impact settles back to zero. We now highlight the main results. Scenario #1: A significant drop but not a crash. This scenario consists of a negative 20% YoY shock to equity prices. According to our analysis, such a shock would have a relatively small negative effect. Specifically, a 20% drop would subtract 2-3 tenths of a percentage point from Italian YoY GDP growth, over the next year or so, and shave off a tenth of a point or so for another four quarters. The impact on euro area growth is similar, though the negative shock is absorbed a little more quickly. Scenario #2: A severe drop with real effects. Our next step is to increase the size of the shock. A 30% shock begins to have a noticeable impact on GDP growth both in Italy and in the euro area. But we find that a 40% YoY drop in equity prices really starts to have a sizeable and prolonged impact on economic growth both in Italy and on the euro area as a whole. Under this scenario, the slowdown in GDP growth would be deeper, and slower growth would drag for several quarters, with the negative impact being the sharpest three quarters after the shock. A shock of this size would likely imply non-negligible macro risks. Yield curve simulations. Finally, we look at how the Italian yield curve might react to a negative equity price shock. We find that a 20% shock to the Italian MSCI index would be followed by an initial steepening of the Italian yield curve, but subsequently the curve flattens noticeably and stays flat for several quarters, before gradually reverting back to normal. While this may seem initially strange, we do find a plausible explanation. The curve might steepen initially if investors were to buy short-dated bills, on the expectation that interest rates might fall soon. Investors might anticipate that the central bank might react to the equity price shock by cutting rates. The steepening peaks at about 20bp after four quarters and unwinds very quickly thereafter as the curve begins to flatten.
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Oh, Chicken Licken, What Have You Done
March 13, 2007
By Serhan Cevik | London
One day when Chicken Licken was scratching among the leaves, an acorn fell out of the sky and struck her on the tail. ‘Oh,’ said Chicken Licken, ‘the sky is falling! I am going to tell the King.’ So she went along until she met Henny Penny. ‘Good morning Chicken Licken, where are you going?’ ‘Oh, Henny Penny, the sky is falling and I am going to tell the King.’ ‘How do you know the sky is falling?’ asked Henny Penny. ‘I saw it with my own eyes, I heard it with my own ears, and a piece of it fell on my tail!’ said Chicken Licken. ‘Then I will go with you,’ said Henny Penny. — An old nursery tale Global volatility is a challenge, but the sky is not falling over the Turkish economy. In today’s global environment shaped by economic imbalances as well as structural changes, it is not surprising to experience occasional bursts of volatility in financial markets, as has happened several times in recent years. But these ‘corrections’ all around the world are actually a necessary adjustment, in our view, helping to keep the price of risk in line with underlying factors and the rate of economic growth on a sustainable track. Of course, we may still face new, even more challenging tests (like a dislocation in the derivatives market) in the future, but the strength of economic fundamentals will ultimately determine the quality of economic developments. Take, for example, the much debated and widely quoted Turkish case. With every bit of noise, the band of catastrophists and hypochondriacs puts forward cataclysmic scenarios suggesting the imminent collapse of the economy, even though it has continuously outperformed expectations and become one of the fastest growing economies in the world. Being a carry-trade magnet exposes Turkey to changes in global risk appetite. We believe that Turkey is a strategic investment opportunity offering higher returns across all asset classes. Nevertheless, it has also become a carry-trade magnet, especially with the abundance of global liquidity (regardless of how you measure it) and capital flows into high-yielding markets. Indeed, while the share of foreign direct investment and long-term loans has increased above 70% of the current account deficit, non-resident investors have kept bringing in more and more in portfolio flows as well. In addition to owning 70% of the free float in the Turkish equity market, non-residents have also increased their exposure in the domestic fixed-income market. According to the latest figures (covering until February 23), foreign holdings of domestic government debt surged to 43.2 billion lira, from 36.8 billion lira at the end of last year and 21.2 billion lira in June. Put differently, foreign investors now account for 36.6% of non-bank holdings of domestic government debt, up from 20.7% in last June and 11.5% at the end of 2003. Although such an exposure to liquidity-driven capital flows makes Turkey sensitive to changes in global liquidity conditions and risk appetite, the economy is now on a stronger footing and therefore can withstand financial volatility. Turkey’s macroeconomic normalization is not a by-product of abundant global liquidity. We can — and indeed have — come up with fancy econometric models to show underlying reasons for our optimism about Turkey’s economic prospects. But, to be honest, everything boils down to whether macroeconomic normalization is a by-product of the abundance of global liquidity or a secular result of prudent policies and structural reforms. We all know that the Turkish economy has broken its boom-bust cycle and expanded at a staggering rate of 7.4%, on average, in the last five years, while disinflating from 80% to the single-digit territory. Even so, these figures may not be enough to reach a conclusive verdict. This is why we prefer to follow the best and most comprehensive measure of economic performance — total factor productivity growth, which shows not just the extent of growth but also quality improvements. After growing at a disappointing 0.5% a year in the 1990s, total factor productivity has surged by 4.8% in the post-crisis period. This tenfold increase in total factor productivity growth, not global liquidity, is the most important determinant of economic developments and the attraction for capital flows. Prudent policies and structural reforms are the best shield against external shocks. In our opinion, fiscal consolidation — reducing the budget deficit from 16.5% of GDP in 2001 to 0.7% last year — is the key factor driving the normalization of Turkey’s economic landscape. When real interest rates on government bonds were more than 40%, no business model could generate comparable returns on capital. As a result, the whole economic system turned into an unsustainable financial endeavor, forcing even non-financial companies to earn as much as 80% of income from financial transactions. That was how distorted the Turkish economy was. But prudent policies and structural reforms have helped to remove distortions and encouraged the private sector to re-focus, once again, on the real economy. This is the heart of the matter. Even though Turkey is exposed to global crosscurrents — giving catastrophists a moment of ‘glory’ every once in a while — fundamental improvements will keep the economy on a robust, sustainable growth path, in our view.
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