Wealth Strategies
GUEST ARTICLE: GAM Ponders Risk That Market Falls Trigger A Recession

What are the risks that further market declines could cause a global recession?
Falls in global markets can be a reflection of underlying
economic worries, but the cause-effect process can flip and sharp
selling to asset classes can hit the “real economy”. In this
commentary on recent moves and spikes in volatility, Larry
Hatheway, group chief economist at GAM, the Zurich-listed wealth
management house, examines whether there is a risk of this with
the current market performance. The views expressed are his own
and not necessarily shared by the editors of this news
service.
Turbulent conditions in financial markets in the first two months
of 2016 have raised questions about the health of the global
economy. As we wrote at the end of January, 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 Middle East
tensions. Policy-making has also come into question. Doubts about
the Federal Reserve's “normalisation” plan, 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.
Speed matters
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 (for example, 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 Case, John Quigley and Robert Shiller suggests
“at best weak evidence of a link between stock market wealth and
consumption” in the US. 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 per cent fall in equity
market capitalisation - similar to the market declines of early
2016 - would on their estimates trim US consumption by $25-$40
billion annually (relative to total US annual consumption of
about $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 per cent is held by about 10 per cent
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. 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.
Watch the credit formation
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 per cent 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.