Stock shock: The threat to global growth

(iStock)
(iStock)

London - Central banks may have rediscovered their mojo in stock markets.

After speculation earlier this year that easier monetary policy no longer had what it took to lift equities, last week’s stimulus shifts from the European Central Bank (ECB) and the People’s Bank of China helped propel the MSCI World Index to its highest since the middle of August.

That markets are skittish again and remain beneath their peaks nevertheless has economists debating how much power equities wield over global growth. The worrying answer is quite a bit, according to a report from Oxford Economics, which notes the recent slide in stocks is similar in scale to that seen in 1998.

“It is unclear whether the sell-off is over or has slightly paused; in the latter case we could be headed for a potentially very serious equity slump by historic standards,” economists Adam Slater and Melanie Rama said in their report.

“A sharp correction in global equity prices would pose a significant threat to the global economy.”

By reducing wealth, Oxford’s economic models suggest a 15% drop in the MSCI could cut the level of world gross domestic product by as much as 0.7% after two years. A 30% shock would knock off as much as 1.5%.

Developed world

Advanced economies would suffer the most because their stock capitalizations as a percentage of GDP are bigger than those of emerging markets. The ratios in the US, the UK, Switzerland and Canada all top 100%, according to Oxford.

So what could central banks do if their equity markets entered a downdraft? Keeping interest rates at current levels in the US or cutting them elsewhere could limit the decline in world GDP to 0.4% from 0.7% if stocks fell 15%.

But the more severe the economic shock, the less potent policy becomes. Global GDP would still be reduced by 1.1% if stocks slid 30% even with central-bank support, compared with 1.5% in case of stable policy, according to Slater and Rama.

The reason for the pattern is that interest rates are already at rock bottom in many economies, leaving policy makers with quantitative easing and other unconventional tools.

Even worse news is the suggestion that the economic impact of falling stocks could be greater than their simulations suggest if weaker equities dragged down consumer and business sentiment as well as wealth. Add a confidence shock to the model and that outweighs the cushioning impact of looser policy, said Slater and Rama.

With central banks able to save stocks from economic headwinds, the fabled central banking put option may still be in place. There seems to be none for the world economy if stocks hit the skids.

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