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   Investment Thoughts - Macro Observations

Economists are calm, even if equities are not
The start of 2016 has been a turbulent time in the world’s equity markets. The world’s economies have been far less volatile. Once again, economics and markets seem to be moving in different directions.

This divergence may well continue. The relationship between equities and economies is a lot looser than people think – the S&P is not a barometer for the health of the US economy, the Nikkei tells us little about Japan, and the FTSE has barely a hint of a British accent. Here are five reasons why equity volatility may well be ignored in the real world:









Equities are a tiny part of the economy. If we think of an economy as being made up of a trinity of large companies (quoted on stock markets), small companies and the government sector, then large companies are the most insignificant of the three. In the United States listed companies account for perhaps 15% of economic activity. This matters because a lot of economic growth is coming from small companies at the moment – it is small companies that are behind the momentum of the European and the American economies.










Economies are service sector dominated, equity markets are not. There often seems to be an assumption that the composition of the equity market should be the same as the composition of the economy – but this just is not true. Equity markets disproportionately favour the manufacturing and commodity sectors – nearly half the earnings of the US equity market come from these sources. However, the US private sector is about 85% service sector companies. China’s move towards a more consumer orientated economy has led to the service sector playing a larger role – consumer services are the area of the economy to watch, but they are not a dominant part of the equity market.










Cost of capital is not a problem at the moment. One way that equity market weakness can impact an economy is by increasing the cost of companies raising capital. Large companies do use the equity market to raise funding. However the global economy today is hardly capital constrained. Profits are close to record highs in most economies, banks are more inclined to lend money in Europe and the United States, and inter-company credit (a critical form of lending) is on the rise. While bank lending in Asia is likely to be more constrained as the rapid credit expansion of the last few years gives way to moderation and deleveraging, this is not a global phenomenon.












The wealth effect from equities is limited. Most people do not own equities. More Americans own a cat than own equity directly, and less than half of the US population own equities even when indirect holdings like pension funds are included. The asset that matters to most people is housing – home ownership is a critical part of household wealth in many countries. The increase in house prices in the US and the stability of property prices in top tier cities in China more than offsets the movement in equity prices for most of the economy. Moreover, wealth effects tend to have less importance if the labour market is strengthening. The strength of the US labour market, with more and more people getting pay increases, is what matters to growth. Even the European labour market, long a source of concern, is starting to improve.












We have not (yet) seen a more general crisis of confidence. For all the rational reasons why equity volatility should not impact financial markets, there is still room for irrationality. What economists call “animal spirits” can be affected by any number of factors. It is possible that the weakness of equity markets creates a more general crisis of confidence – however unfounded that may be. So far this does not appear to be the case. Consumer confidence data is a flawed indicator, but it is not showing undue concern about the noise from financial markets. Google Trends is not reporting any increase in global web searches for the word “recession”, which is as good an indicator of indifference as anything. This situation could change, of course, but for now the situation seems relatively benign.


Economists cannot entirely ignore the moves in financial markets. There are transmission mechanisms to the real world. For now, however, these transmission mechanisms are not especially alarming. The movements of equities run counter to the general picture of a modest US and European economic expansion, and a modest Asian economic slowdown. For now, economists are indifferent to the whirling cycle of equities.


Paul Donovan’s latest book “The Truth About Inflation” was published by Routledge in April 2015. Visit for more research. Paul's commentaries in the UBS series of documentaries on Nobel Laureates in economics is available at


This document has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.


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UBS, January 2016-Global Economist, Paul Donovan







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