Can This Be for Real?

I don’t know if it’s just me, but there is something disturbing about the recent market behavior. If one were to proxy the state of the (real) world with the stock market index, one would have to conclude that consumers, businesses and governments have turned into schizophrenics.

Surely, that’s not the case (though I’ll reserve my judgment about the latter group for later). News regarding the economic outlook has been by no means commensurate to the vertical moves we saw in the market last week. But since many have already thrown the “efficient market hypothesis” out of the window, here I’ll focus on a somewhat different question:

Is it possible to get a negative feedback loop, from volatile—or declining—markets to the real economy (and back to the markets) and turn the sudden shift in investor mood into a self-fulfilling “prophecy”?

To answer that, let’s first see what the possible channels of transmission are.

First, we have the good old wealth effects—declines in household wealth as a result of falling stock prices would tend to be associated with a drop in consumer demand. However, typical literature estimates for wealth effects are small, implying a tiny impact, unless we see the kind of drawdown we saw back in 2008/early-09.

Second, we have the “Tobin-q” link between stock prices and corporate investment, which conjectures that whenever the market value of a firm exceeds the replacement cost of its capital stock, firms will tend to invest more. Empirical support for this theory is very weak, however. One reason is that firms tend to view internally generated cashflow as the cheapest source of financing and equity as the most expensive one—so that cashflow is empirically more important in explaining investment than the equity cost of capital.

In addition, corporate investment is also tied to the outlook for final demand. Not only does a robust demand outlook generate new investment opportunities; demand also generates cashflow, which in turn means additional stocks of cheap corporate financing. This does not mean that equity capital is unimportant—only that the cost of issuance is sufficiently high that it usually is not the primary source of finance.

The same cannot be told of credit though, and here is where things can get tricky. Corporate spreads saw similarly vertical moves as equities last week, only upwards. Here it’s worth recalling Bernanke’s financial accelerator effect, whereby higher risk premia (due to higher volatility) lead to higher required rates of return, a deterioration in the perveiced health of borrowers balance sheet, and a drop in bank credit. On top of that, market indicators of stress in bank-funding markets (LIBOR-OIS, bank CDS spreads and so on) have also been moving in the wrong direction, raising concerns about a credit-crunch “encore” accentuated by poor bank funding conditions.

Starting from the former—the general carnage notwithstanding, credit markets were not exactly closed last week. Corporate issuance did go ahead in many cases, only that investors demanded higher yields and were more selective, depending on the name. In addition, much of the negative focus has been on financials: Indicatively, commercial paper funding for non-financial corporates has remained virtually flat throughout May (including last week), while that for financials (domestic, as well as foreign) has declined by $50 billlion—some 9% of the outstanding stock.

Turning to financials: Here I want to first make a distinction between cash and liquidity. Some have argued that, since financial institutions have tons of cash sitting at their respective central banks, surely funding problems can’t be the issue here. Even European institutions, which have been the focus of strains recently, can’t really be said to have funding problems, since the ECB has gone all the way in helping them: Not only with unlimited long-term refinancing operations at fixed rates, but also with purchases of “toxic” ClubMed bonds. All that is true. In other words, I would personally ignore the LIBOR-OIS spread, which became very fashionable during the 2008 crisis, as a signal of an impending credit crunch.

However… cash does not equal liquidity. As Pimco’s Paul McCulley said a few years back, liquidity is a state of mind. Banks’ holdings of large piles of cash reserves say little about their willingness to lend. One source where information about the latter can be found is the latest Senior Loan Officer Opinion Survey (SLOOS). This suggests that credit conditions remain tight for reasons including reduced tolerance for risk and a still uncertain macroeconomic outlook.

Importantly, the cash sitting around says little about demand for credit. Here, the SLOOS points to mostly unchanged conditions in the demand for credit for non-financial firms, with the balance towards a still weakening demand. In addition, only a fraction of reporting banks believed that, for those cases where credit did actually expand, the reason was a rise in investment.

The bottom line here is that, while market indicators may point to stress in the financial sector, (a) the stress is only theoretical, given the effective backstop by the ECB and the Fed; and (b) any spillovers to the real sector are limited. This is because, given the backstop, changes in the supply of credit have not been driven by banks’ theoretical ability to lend but by their tolerance for risk, a lukewarm credit demand and ongoing uncertainty about the economic outlook.

So unless the momentum of improvement of the global economy (especially that of private sector demand) turns negative, it will be difficult to see a spillover from the markets alone to the real sector. Note that this is what makes the current case different from 2008: At that time, there was a clear negative momentum underway in the real sector, starting from a collapsing housing market that fed through to labor markets, credit markets and, eventually, the global financial system.

Still—I said it will be difficult, but not impossible. The one channel of transmission I have not mentioned is confidence. I would have personally dismissed it as significant a while back, especially since at least one study that I’ve seen fails to find a significant impact of (transitory) bouts of market volatility on consumer confidence.

But I would say that 2008 changed the picture. The drawdowns we saw in labor markets or in consumer spending were considerably larger than what standard economic models of consumption or unemployment would have predicted. This tells me that we can not entirely discard the impact of sharp market drawdowns on the attitudes of households and businesses. And here, one can only hope that these guys have better things to do than checking their stocks, while the markets work through their schizophrenia—alone!


Originally published at Models & Agents and reproduced here with the author’s permission.   

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