17th February 2016
Larry Hatheway, Group Chief Economist and Head of Multi Asset Portfolio Solutions at GAM asks will the market sell-off precipitate global recession.
Turbulent conditions in financial markets in the first two months of 2016 have raised questions about the health of the global economy. We think the market sell-off — including its breadth, the poor performance of many non-cyclicals and even the extent of the crude oil price drop — cannot fully be explained by growth disappointments. The weeks since then have only reinforced that view.
Take bank shares — particularly in Europe — as an example. To be sure, financials are cyclical and can be expected to fall by more than the broad market. But bank share price declines, price-to-book valuations, and credit default swap levels imply an extent of asset and earnings impairment inconsistent with probable growth outcomes.
Other factors have contributed to the rise in risk premiums. These include political uncertainty, such as the fallout over the immigration crisis in Europe, fears over Brexit, the rise of non-traditional candidates in the US elections, or Mideast tensions. Policy-making has also come into question. Doubts about Fed ‘normalisation,’ the divergence of global monetary policy, interventions by Chinese authorities, and about the efficacy of EU bank resolution mechanisms have also unsettled markets. Exiting of crowded positions may have also contributed to sharp market moves. That may explain why already out-of-favour assets (e.g. emerging equities or currencies) have not fared as poorly as some developed market assets during the most recent bouts of market pressure.
But while the drop in asset prices appears excessive relative to fundamental shifts in the world economy, it is still possible that the speed, violence and extent of the declines could deal a blow to global growth, potentially creating a self-fulfilling outcome. To consider that possibility, it is useful to consider how financial dislocation might impact the real economy. Three key transmission channels exist:
1. Negative wealth and sentiment effects on household consumption;
2. A higher cost of capital on business activity;
3. An impairment of credit supply (via banks and/or capital markets).
In most economies empirical work on the sensitivity of consumption to changes in wealth suggests that declines in portfolio wealth (e.g. equities and bonds) have relatively small impacts on consumer spending. What matters more is the price of real estate (housing). For example, a paper authored by Karl E. Case, John M. Quigley and Robert J. Shiller suggests “at best weak evidence of a link between stock market wealth and consumption” in the US[i]. Based on their estimates the impact of falling stock markets on US consumption is roughly a quarter the impact of falling house prices. A 10% fall in equity market capitalisation — similar to the market declines of early 2016 — would on their estimates trim US consumption by USD 25-40 billion annually (relative to total US annual consumption of about USD 10 trillion). And that figure assumes no potential offsets, such as the positive impacts on household purchasing power via lower petrol prices.
For the majority of Americans, home prices are more important because direct holdings of portfolio wealth are significantly concentrated — roughly 90% is held by about 10% of US households. Given relatively low direct household ownership of equities in Europe, Japan or China, it would be surprising if the modest impact of changes in portfolio wealth on consumption observed in the US were much different elsewhere.
Falling markets could, of course, restrain business outlays. But in the absence of credit impairment, the impact of increases in the cost of capital on business investment spending appears weak and inconsistent across countries[ii]. Since business spending has been subdued in advanced economies during most of the post-crisis period, growth is arguably less susceptible today to sharp declines in capital spending than would have been the case, for instance, at the end of the dot-com bubble.
Financial events, when they do significantly impair economic activity, almost always do so by disrupting the flow of credit. That is a potential concern today in Europe, where the recovery remains fragile. Still, most credit indicators have indicated improved lending conditions, underpinned by broad-based increases in credit demand. But to the extent that weak European equity markets, dislocations in bank bond financing and rising credit default swap rates were to cause banks in Europe to rein in lending, fears of renewed recession could be justified. In the US, financial conditions have already tightened in corporate bond markets, though much of the tightening has been sector specific (e.g. energy) or related to weak corporate credit fundamentals (elsewhere in high yield).
Credit formation will therefore bear close scrutiny in the weeks and months ahead. Still, beyond the global financial crisis of 2008 and those that befell emerging economies (1998, 1995 and during the 1980s) there is little evidence to suggest that equity market corrections or even ‘bear markets’ have strong or lasting impacts on credit formation. Equity market declines of 10-15% are not uncommon — on our count there have been 17 such episodes since 1970 (based on three-month change for the S&P500 or MSCI World). Yet credit crunches and ensuing recessions are much rarer — seven US recessions, for example, over the same timeframe. And in most cases those recessions and episodes of market weakness owed to other factors, for example the oil shocks of the 1970s or the housing crisis of 2008. As a rule, therefore, market corrections do not lead to sudden credit stops and recessions.
By way of summary, the following conclusions emerge:
· Markets were too sanguine about economic fundamentals at the end of 2015. The data since then have come in weaker than expected. Markets have understandably sold off. Still the extent of the declines has been excessive relative to the fundamentals.
· Unless economic weakness becomes even more pronounced on its own (e.g. China hard landing) or policy errors are compounded, it appears unlikely that the market setbacks to date will leave large or lasting negative impacts on global growth.
· The upshot is that risk assets look oversold and should recover. In contrast to other episodes of market weakness since the global financial crisis, however, the recovery process is likely to be longer and more uncertain, for the simple reason that policy is less likely to come to the rescue. Furthermore, QE and negative interest rates have adverse impacts on bank profitability and hence may not be as effective in stabilising investor sentiment, should they be re-deployed again.
· We expect a period of continued volatile and uncertain markets, with relief only being re-established as signs of improved growth in the US, Europe and Japan — as well as stabilisation in China — become more evident. That will take time.