May 24, 2018

News in Charts: Global Equities are 40% Overvalued – Who is Vulnerable to a Correction?

by Fathom Consulting

As many of our clients will be aware, one of our current global big-picture calls is the fact that asset price bubbles are inflating and will most likely get bigger before eventually bursting. Based on some simple arithmetic and an assumption about the size of the equity risk premium, equities are overvalued by some 40% globally. To gauge which countries are most at risk to a correction, we have run this scenario, with some caveats around it, through our Financial Vulnerability Indicator (FVI), while also contrasting the results with what happened during the dot-com crash in the early 2000s. The results of our simulations show that maligned oil exporters and under-performing emerging markets ultimately lose out should global equities fall by 40%.

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In the long run, the gap between GDP growth (g) and the real interest rate (r) is approximately zero. At the moment, growth is running ahead of the real interest rate, but whether g falls, or r rises, the gap will close eventually, as it always has done. When the gap closes, and regardless of through which channel, it spells bad news for equities.

Large equity market swings are nothing new. During the early 2000s, the gap between r and g closed, albeit from a considerably narrower level, as g fell faster than r. A combination of fallout from the Asian crisis of the late 1990s and the dot-com crash in the early 2000s caused a sharp fall in equities of around 40% globally, with the S&P 500 index falling by slightly less. Annual GDP growth in the US fell from 4% in 2000 to 1% in 2001, with the country narrowly avoiding a recession after the Federal Reserve cut interest rates sharply by 475 basis points.

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However, financial markets are more integrated than ever before, meaning it is much more difficult to judge which countries and which institutions would be at risk should a 40% equity price correction materialize again. We developed our FVI to address this question, among many others.

In order to simulate what a 40% equity price correction along with the macroeconomic fallouts from such an event would mean for the global economy, we have imposed a number of assumptions on the FVI. These include negative shocks to GDP growth and variance/covariance analysis to gauge how a 40% equity market correction would ripple through other equity markets across the world and sharp falls in commodity prices.

The results confirmed that highly financially integrated countries such as Singapore and Hong Kong would see their vulnerability to crises rise substantially in the world where equity prices fall 40%. In addition, oil exporting countries including Turkmenistan, Angola and Russia (countries with high and positive oil balances) were among the worst hit in this scenario.

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