Blog Post
The gap between the real and financial sides of the economy
Mon, Apr 22, 2024
Body
In Q1 of 2024, positive climate on financial markets consolidated due to prospects for recalibration of monetary policy across the world’s main economies. This euphoria was induced by recent developments relating to the Artificial Intelligence Revolution and the financial performance of listed companies. According to figures recently released by the Bureau of Economic Analysis, profits of the companies in the US economy grew by 8.6% YoY in Q4 of 2023, the strongest pace since Q1 of 2022.
At the end of the past quarter, the MSCI All country index (a benchmark for the global stock markets) hit record high levels, a noticeable feat of the stock market in United States of America (the largest in the world, with a market capitalization of over USD 25tn). In fact, the equity risk premium for the US market declined in March to its lowest level since the spring of 2021, following the coronavirus pandemic. In this context, the cyclically adjusted PE ratio for the S&P 500 Index in the United States hit its highest level since February 2022 (the month of the outbreak of the Ukrainian crisis), according to the Shiller database.
The current level of the PE ratio is above the historical average, reflecting the fact that the US stock market is presently overvalued. The positive climate on the financial side of the economy had spill-over impact for the activity across the real side of the economy recently. For instance, the world economy continued to increase in March, while the growth pace accelerated to its highest since June 2023, according to the PMI Composite indicator estimated by Markit Economics. This evolution was determined by the improvement of new orders geared toward stabilization of international trade (with impact for manufacturing) and the overall positive climate on labor markets supporting the services sector.
According to figures recently released by the Bureau of Economic Analysis from Netherlands, the volume of global trade resumed growth in January, climbing by 0.4% YoY, the strongest pace since March 2023. However, the real economy continues to present a pace below its potential at the global level, as reflected by the slowing down of the YoY pace of the industrial production to 1.2% in January 2024, the weakest dynamics since October 2023.
The persistence of the negative output gap at the global economy level is determined by the consequences of the overlapping shocks, including the high levels of the real interest rates and the persistence of the geo-political tensions. If we take into account levels of the Federal Funds Effective Rate and the dynamics of the consumer prices based on PCE indicator (Personal Consumption Expenditure), real financing costs in the largest economy in the world (a benchmark for the global financing costs) hit its maximum since the Summer of 2007 (the outbreak of the Great Financial Crisis) at the beginning of 2024. This in turn, fuels the increasing risk of an adjustment in the US economy (the largest in the world, with a nominal GDP of USD 28tn at the end of 2023) in the coming quarters, after the GDP accelerated to 2.5% YoY in 2023.
This scenario is supported by the persistence of interest rates spreading (10 YR vs. 3 months) in negative territories and by the continued contraction of leading YoY indicators in United States in Q1 of 2024, according to the statistics released by Federal Reserve and Conference Board.
Overall, gaps between the sentiment toward the financial markets and the actual climate on the real side of the economy have recently widened, being felt most noticeably at high levels in Europe - the region mostly affected by the exogenous shocks in recent years. In this context, the probability of adjustment pertaining to this gap in the short-run is increasing, especially in the context of persisting risk factors, including geo-political fragmentation, pressures in terms of non-performing loans, challenges in terms of public finance (including the high levels of the public debt/GDP ratio), and political climate (elections are scheduled in countries contributing by more than 50% to the global GDP this year).
Considering recent developments with macro-financial indicators, the probability of adjustment is higher on the financial side of the economy in the coming months, a scenario also supported by the fact that real financing costs are forecasted to persist at high levels. In other words, in a core scenario, the stock markets should adjust to healthier levels, allowing the real side of the economy to continue its recovery process and avoid a hard landing.
Andrei Radulescu is a macroeconomist with post-university studies and professional experience in Portugal and Romania. He is also a Senior Researcher at the Institute for World Economy and Macro-Modeling Centre at the Romanian Academy. Radulescu joined the Bretton Woods Committee in 2023.
The gap between the real and financial sides of the economy
Mon, Apr 22, 2024
In Q1 of 2024, positive climate on financial markets consolidated due to prospects for recalibration of monetary policy across the world’s main economies. This euphoria was induced by recent developments relating to the Artificial Intelligence Revolution and the financial performance of listed companies. According to figures recently released by the Bureau of Economic Analysis, profits of the companies in the US economy grew by 8.6% YoY in Q4 of 2023, the strongest pace since Q1 of 2022.
At the end of the past quarter, the MSCI All country index (a benchmark for the global stock markets) hit record high levels, a noticeable feat of the stock market in United States of America (the largest in the world, with a market capitalization of over USD 25tn). In fact, the equity risk premium for the US market declined in March to its lowest level since the spring of 2021, following the coronavirus pandemic. In this context, the cyclically adjusted PE ratio for the S&P 500 Index in the United States hit its highest level since February 2022 (the month of the outbreak of the Ukrainian crisis), according to the Shiller database.
The current level of the PE ratio is above the historical average, reflecting the fact that the US stock market is presently overvalued. The positive climate on the financial side of the economy had spill-over impact for the activity across the real side of the economy recently. For instance, the world economy continued to increase in March, while the growth pace accelerated to its highest since June 2023, according to the PMI Composite indicator estimated by Markit Economics. This evolution was determined by the improvement of new orders geared toward stabilization of international trade (with impact for manufacturing) and the overall positive climate on labor markets supporting the services sector.
According to figures recently released by the Bureau of Economic Analysis from Netherlands, the volume of global trade resumed growth in January, climbing by 0.4% YoY, the strongest pace since March 2023. However, the real economy continues to present a pace below its potential at the global level, as reflected by the slowing down of the YoY pace of the industrial production to 1.2% in January 2024, the weakest dynamics since October 2023.
The persistence of the negative output gap at the global economy level is determined by the consequences of the overlapping shocks, including the high levels of the real interest rates and the persistence of the geo-political tensions. If we take into account levels of the Federal Funds Effective Rate and the dynamics of the consumer prices based on PCE indicator (Personal Consumption Expenditure), real financing costs in the largest economy in the world (a benchmark for the global financing costs) hit its maximum since the Summer of 2007 (the outbreak of the Great Financial Crisis) at the beginning of 2024. This in turn, fuels the increasing risk of an adjustment in the US economy (the largest in the world, with a nominal GDP of USD 28tn at the end of 2023) in the coming quarters, after the GDP accelerated to 2.5% YoY in 2023.
This scenario is supported by the persistence of interest rates spreading (10 YR vs. 3 months) in negative territories and by the continued contraction of leading YoY indicators in United States in Q1 of 2024, according to the statistics released by Federal Reserve and Conference Board.
Overall, gaps between the sentiment toward the financial markets and the actual climate on the real side of the economy have recently widened, being felt most noticeably at high levels in Europe - the region mostly affected by the exogenous shocks in recent years. In this context, the probability of adjustment pertaining to this gap in the short-run is increasing, especially in the context of persisting risk factors, including geo-political fragmentation, pressures in terms of non-performing loans, challenges in terms of public finance (including the high levels of the public debt/GDP ratio), and political climate (elections are scheduled in countries contributing by more than 50% to the global GDP this year).
Considering recent developments with macro-financial indicators, the probability of adjustment is higher on the financial side of the economy in the coming months, a scenario also supported by the fact that real financing costs are forecasted to persist at high levels. In other words, in a core scenario, the stock markets should adjust to healthier levels, allowing the real side of the economy to continue its recovery process and avoid a hard landing.
Andrei Radulescu is a macroeconomist with post-university studies and professional experience in Portugal and Romania. He is also a Senior Researcher at the Institute for World Economy and Macro-Modeling Centre at the Romanian Academy. Radulescu joined the Bretton Woods Committee in 2023.