A report by Aaron Gurwitz, Head of Global Investment Strategy at Barclays Wealth

Part of the recent equity market rally has been driven by an increase in risk appetite, which might also be termed a less pessimistic mood in the markets.

As well as taking heart from a number of government initiatives to return the financial system to health, markets have been buoyed by the fact that the ‘worst-case scenario’ – a depression to rival that of the 1930s – now looks less likely than it did at the start of the year.

Quantifying the exact relationship between the potential threat of a dire economic outcome and the performance of individual ‘risky’ asset classes is difficult. However, the work of Robert Barro, a US economist, is instructive.

Using reasonable assumptions, Barro has shown how small changes in investors’ estimates of very unlikely but very bad economic outcomes can have huge effects on asset prices. Indeed, Barro’s work suggests that the dramatic market moves seen over the past 18 months have not been driven by adjustments to the consensus outlook for corporate earnings but rather by small changes in the perceived likelihood of a macroeconomic disaster.

Barro’s framework provides a coherent explanation of financial market performance since the onset of the recession and, perhaps more importantly, some guidance on future returns from ‘risky’ assets.

Barro’s analysis is interesting because for most of 2008, events seemed to be following their usual ‘recessionary’ course, with problems in the housing market gradually spreading elsewhere. Most risk assets were already performing poorly as the US unemployment rate drifted upward steadily from 4.9% in December 2007 to 6.2% in August 2008.

But only a very few (and now vindicated) observers were predicting anything as bad as the early 1980s downturn.

Perceived probabilities of a dire outcome changed after the Lehman collapse

When global credit markets shut down after the bankruptcy of Lehman Brothers, anxiety levels spiked. The consensus forecast became ‘the worst downturn since the great depression,’ and comparisons of the current period with the 1930s proliferated.

One central theme of the discussions of depression economics was that government action was necessary to avoid a prolonged and severe global downturn. Unfortunately for risk assets, the initial government response was far from encouraging. Particularly worrisome were erratic efforts by the Bush administration to stabilise the banking system, the outgoing US Congress’s failure to enact an emergency fiscal stimulus package, initial stumbles by the Obama team, scepticism about the effectiveness of the fiscal stimulus the new Congress finally did pass, a sluggish European Central Bank response to the crisis, and a general sense that European governments felt no need to be part of the solution to a problem that was ‘made in America’.

Government action takes time to convince the market

In our view, a growing sense that governments in 2009 weren’t any more up to the job than they had been in 1929–30 increased the perceived likelihood of a depression from ‘not impossible’ to ‘a serious risk.’ In Barro’s approach, this could easily account for the additional 20% decline in global equities from the start of 2009 until 6th March.

Moreover, the growing sense that, while each specific initiative might be imperfect on a standalone basis, the cumulative impact of governments’ recovery policies could do the job seems like a good ‘Barroian’ justification for the subsequent recent recovery in equity markets to late 2008 price levels.

A useful conceptual framework

The last year-and-a-half of equity market performance does not prove that small changes in the perceived likelihood of a disaster have large market impacts, but it is consistent with that idea. At the very least, the approach provides a useful fundamental framework for thinking about whether we’ve had only a ‘bear market rally’ and what risk asset markets are likely to do next.

If we have dodged the ‘depression bullet,’ and are therefore in the later phases of nothing worse than a severe recession, we should expect some further near-term recovery in risk asset prices. This outcome depends on investors maintaining their current less pessimistic view of the likely effectiveness of government policies.

If, for example, fiscal stimulus works its way into consumers’ pockets but retail sales continue to decline, that faith will be tested.

Overall, we are less pessimistic than we were a few months ago, and that’s a very good thing. We hope – and expect – to be optimistic soon; that will be even better.