Nicholas Vause and Carolin Pflueger
Recently, Pflueger, Siriwardane and Sunderam (2020) proposed a new measure of investor risk perceptions based on the cross-section of stock prices. Using that measure, they found that when risk perceptions are high, the cost of capital of risky firms is high and subsequently real investment and employment decline in the United States. In this post, we show that similar relationships exist in the United Kingdom. In 2023 Q1, the UK measure fell to its lowest level since the outbreak of the Covid pandemic, indicating higher risk perceptions and potentially foreshadowing weaker economic activity. This indicator may be helpful for policymakers, as it could serve as a useful measure of risk perceptions relevant for future economic developments and monetary policy.
Introducing the price of volatile stocks as a measure of risk perceptions
Economists such as Keynes, Minsky and Kindleberger have highlighted the importance of investor risk perceptions in driving economic fluctuations. In such accounts: (i) a negative economic shock causes perceptions of risk to rise; (ii) investors then value the safety of government bonds and charge risky firms a higher cost of capital; and (iii) firms invest less and employment and output decline.
Pflueger, Siriwardane and Sunderam (2020) introduce a new measure of risk perceptions, the price of volatile stocks (PVS), motivated by a stylised model of (i), (ii) and (iii). Most simply, PVS is defined as the difference between the average book to market ratio (ie the accounting value of a company relative to its market value) of low minus high-volatility stocks. Intuitively, when investors perceive more risk: risk appetite is low, the price of volatile stocks falls, the book to market ratio of these stocks rises relative to less-volatile stocks, and PVS is low. This matters for the real economy: as investors perceive more risk, they require higher expected returns to supply capital to risky firms, their investment falls and employment and output decline.
The PVS in the UK
We expand the analysis to the UK, up to and including 2023 Q1. To calculate the PVS in the UK, we follow four steps. First, at each quarter-end, we collect book to market ratios for all stocks in the FTSE All-Share index. Second, using daily data on equity prices for the previous two months, we compute the return volatility for these stocks. Third, we group stocks into quintiles based on their return volatilities. Fourth, we compute the PVS as the difference between the average book to market ratio of stocks in the lowest and highest-volatility quintiles.
Chart 1 shows the time series of the UK PVS since the start of 2000, from when the coverage of our data has been reasonably comprehensive. For comparison the US PVS is superimposed. The correlation between the two series is quite high at 53%, suggesting that investor risk perceptions are driven by global factors to a significant degree, potentially consistent with a global financial cycle (Miranda-Agrippino and Rey (2020)). It also shows that the UK PVS fell sharply in 2023 Q1 amidst the banking turmoil in the US and Europe. It declined by 2.2 standard deviations (which means that sharper falls occur in only 1.4% of quarters), reaching levels not seen since the outbreak of Covid in 2020 Q1.
Chart 1: The price of volatile stocks
The relationship between PVS and economic activity in the UK
To investigate how the PVS relates to economic activity, we estimate local projection regressions of the form:
where yt+h denotes a variable related to economic activity at h quarters ahead of the current quarter (t), which is either (i) the investment ratio, defined as the ratio of gross fixed capital formation to gross capital stock net of depreciation; (ii) the output gap as estimated by the Office for Budgetary Responsibility or (iii) the change in the unemployment rate. In addition, RR denotes the real risk-free interest rate, which is an alternative driver of economic activity that we control for, and which is measured as the yield on two-year inflation-indexed gilts. All the variables on the right-hand side of the equation are standardised, so we can interpret their coefficients as the response of economic activity in h quarters’ time to a one-standard-deviation shock to the right-hand-side variable.
Chart 2 shows the estimated responses of the investment ratio, output gap and unemployment rate to a one standard deviation positive shock to the PVS in the UK. The solid lines show the central estimates and the shading shows 95% confidence bands. A positive shock means that investor risk perceptions have decreased. This boosts the investment ratio and the output gap and leads to a fall in the unemployment rate, with peak effects 3–8 quarters after the shock. The magnitudes and timings of the estimated responses are similar to those found in the US by Pflueger, Siriwardane and Sunderam (2020), suggesting that risk perceptions are similarly relevant for economic activity in the UK as in the US.
Chart 2: Estimated responses of economic activity to a one standard deviation positive PVS shock in the UK
In light of these relationships, the 2.2 standard deviation decrease in the UK PVS in 2023 Q1 may foreshadow a tangible decline in economic activity. While these predictions clearly come with significant uncertainty attached, point estimates based on the results above suggest a peak decline in the investment ratio of 0.4 percentage points from its 2023 Q1 level of 3%, a peak decline in the output gap of 1.2 percentage points and a peak increase in the unemployment rate of 0.5 percentage points.
Nicholas Vause works in the Bank’s Capital Markets Division and Carolin Pflueger works at the University of Chicago.
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