With rising rates, markets seem to be reconnecting to the real economy

The stock market dances like a sailboat on the swell that sails on sight! Global financial markets are down for the past few weeks, despite slight upheavals of optimism. The CAC 40 has lost around 19% since the start of 2022. The Euro Stoxx 50 (benchmark index for euro zone markets) has fallen by 20% in 6 months. In the United States, the S&P 500 index plunged 23%.

Investors like to anticipate but they don’t like uncertainty… Stock market variations are therefore governed by expectations of economic agents and investors. In other words, the value of a stock primarily reflects a company’s earnings expectations, the strength of the global economy and market momentum (the rate of acceleration in the price of a security).

In recent weeks, the second dimension has taken over with regard to the political, economic and financial context: war in ukraineeconomic slowdown in China, supply chain issues, forte inflation, interest rate hikesfragmentation of sovereign debt, soaring Italian “spread”… Most “macro” lights are in the red; the stock market too.

The stock market and life

The macro-finance studies the relationship between asset prices and economic fluctuations; between “the stock market and life”. Asset prices correspond to a significant risk premium (additional return compared to a risk-free asset), which varies over time and is correlated to the economic cycle. Stock prices and asset returns are therefore often correlated with economic cycles and changes in macroeconomic fundamentals.

Stock returns also help forecast macroeconomic events such as GDP growth, unemployment, and inflation. We then understand that the connection or disconnection and causality between macroeconomic variables and the stock market remains a central question for investors. academicspolicy makers, investors or fund managers.

We seek to solve the paradox of the chicken and the egg. Indeed, one can wonder whether stock markets are ahead or behind macroeconomic fundamentals. On the one hand, macroeconomic variables influence and help predict stock prices. Economic changes affect discount rates and, at the same time, macroeconomic variables are among the risk factors in stock markets. On the other hand, stock markets can also be lagging indicators, reacting to macroeconomic data. For example, the stock prices can be linked to expected future production.

Stock market fluctuations are notably governed by the expectations of economic agents and investors.
Wikimedia Commons, CC BY-SA

However, the literature does not reach a consensus on the existence, strength and duration of causalities between the stock market and macroeconomic fundamentals, due to the non-linear and varying nature of the relationships. Boom and bust cycles seem to condition the transmissions and spillovers of information between macroeconomic fundamentals and the stock market.

Two decades of progressive disconnection

In a article of recently published research, I analyze the existence and intensity of time-varying bidirectional causality between the stock market and five macroeconomic variables in the United States between 1960 and 2021. By integrating different markets (the money market with a interest rate and money supply, the goods market with inflation and industrial production, and the labor market with unemployment) in an econometric model, it is possible to determine the start and end dates of any causal episode with recent methodology.

Empirical results revealed that these relationships vary over time, especially during economic or financial crises. During the health crisis, this observation was less valid, which might testify to a logout between fundamentals and stock market activity. The Covid crisis may have changed economic relations. We might be in the presence irrational exuberance or speculative bubbles. During the pandemic, markets lived their lives and paid little attention to macroeconomic fundamentals.

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In an other study recent study, which focuses on the links between stock market activity and unemployment, causality tests reveal that lagged stock market realizations have predictive power on unemployment, and vice versa. Indeed, stock prices are particularly impacted by news on unemployment rates, which may contain information on growth and/or the risk premium of stocks.

However, this predictive capacity, which is found in particular during periods of crisis, only occurs sporadically over time. For example, during the dotcom bubble in the early 2000s, the predictive ability of unemployment to the stock market seemed stronger and more persistent than during the Great Recession that followed the 2008 financial crisis. Since then, over time , the intensity of the causalities has been diluted. We can therefore think that the disconnection was gradually confirmed.

Temporary reconnection?

On the other hand, stock market activity in recent weeks seems to be closely correlated with certain macroeconomic fundamentals, such as inflation or the risks of a slowdown in activity.

Indeed, recently, the US central bank has largely increased its rates in the short term term of 0.75 points (which has not been seen since 1994) in an attempt to limit inflationary pressures, which caused market turbulence.

However, this recent reconnection may not last given the findings of the studies mentioned above. It seems mainly to come from a conjunction of events that is panicking investors and the stock markets, averse to on-sight shipping. However, the connection is essential since the financial sphere should be closely linked to the real economy…