- Over the past month, equity markets have been declining, on the fear of recession and heightened uncertainty relating to European and US debt problems.
- In this document, we examine the pass-through from equity prices on the real economy. We conclude that a 10% fall in equity prices would lead to a fall in GDP growth of the order of 0.33pp annualised.
- The timing of the fall in equity prices might bias the estimate downward, as we are yet to see a take-off in the labour market and, with fiscal consolidation moving closer, the financial turmoil could not have come at a worse time.
Lower equities hurt both consumers and corporations
Since the end of July equity prices have been hit hard, as confidence in western leaders’ ability to tackle imminent debt issues has plummeted. The S&P500 shed 16% in a little over two weeks. In this paper, we examine how such a fall feeds into GDP growth and thereby whether the recent decline poses a long-term threat to the real economy.
Generally, equity prices feed into the real economy through a number of channels, with the major ones being consumer and corporate spending (see the chart overleaf for an overview of the dynamics).
Private consumption is particularly affected in the US, where households tend to be much more actively involved in equity markets than in Europe. A fall in equity prices would drive down both the size of equity holdings and household wealth. A mitigating factor to this effect is the reduction in interest rates as equities tumble. However, the overall effect on consumption is negative. Looking at an error correction model (see Appendix) for consumer spending, we estimate the long-term impact of a 10% fall in equity over a quarter would cut private consumption by 0.4pp on average. With consumption making up roughly 70% of GDP, this should reduce GDP by around 0.3% on the year. Though this might not seem very dramatic at first glance, it is worth noting that the recent decline in equity prices is likely to take some time to feed through completely. Hence, not only the magnitude but also the duration of the decline is important.
Corporate spending is influenced both directly and indirectly by equity prices. The direct channel comes through firms’ ability to refinance themselves in the stock markets. This is on average of the same order of magnitude as the effect of the S&P500 on consumer spending. However, there is also an indirect effect from changes in (expected) demand, that is a reduction in consumer spending feeds more than one-to-one into firms’ spending.
These two major channels are supplemented by the indirect effects of the above changes in domestic demand on both inventories and imports. This effect of domestic demand on imports tends to dampen the negative effects of a fall in equity prices.
Looking at the above effects combined, we expect a 10% fall in equity prices over a quarter to lower GDP by 0.08% q/q, equal to about 0.3% q/q annualised.
To get an idea of the dynamics, we have drawn up three scenarios based on the S&P500 index.
- S&P500 recovers to 1350 by year-end and then rises by 10% in 2012.
- S&P500 stays flat at 1230 until end-2012.
- S&P500 declines to 1000 by year-end and stays flat in 2012.
In all three scenarios, the negative impact of equity prices remains throughout H2, due to the lagging nature of the wealth effect. The same goes for corporate spending, where equity prices are already dampening corporate spending. We do not expect this effect to go away until well into H1 12.
By summing the impact on consumer and corporate spending, along with the effect of imports and inventories, we end up with the total impact on GDP growth. It is evident that equity prices are less important now than in both the great recession and the downturn in the early 2000s, when GDP fell by more than 1pp y/y. The overall effect of equity on GDP is still expected to be positive for 2011 as a whole; however, the lagged effects are likely to drag down GDP well into 2012.
A major source of uncertainty regarding the above model is the impact of the timing of the shock. Even though the employment dynamics might be hurt only in the short run, we cannot preclude long-term damage from the current shock to the economy. With the takeoff in the labour market still waiting to be seen, the economy is much less resilient going into the austerity of 2012. This could mean a longer period of subdued job and consumption growth.
