The new coronavirus has caused a pandemic of COVID-19, a respiratory disease for which vaccines and targeted therapeutic treatments are unavailable. The outbreak has created major public-health crises around the world. At the same time, there are growing concerns about the economic consequences as households are required to stay home to slow the spread of the virus. The impact that “pausing” may have on supply chains, households’ demand, and the financial stability of the economy is largely unknown. As a result, policy makers, businesses, and market participants are revising growth expectations for the years to come.
The current situation is unprecedented, and it’s developing rapidly, which is why models that use macroeconomic fundamentals may miss some of the key forces—and may be too slow to update, given the frequency with which macroeconomic data become available. It has long been recognized that asset prices may generally be useful because they reflect investors’ expectations about future payoffs. In particular, the movements in the stock market have received a lot of attention. We provide a perspective on how to interpret movements in the stock market and what they tell us about growth expectations by combining it with asset pricing data from other markets.
Equity markets in the European Union and the United States dropped by as much as 30 percent between mid-February and mid-March. This is an extraordinary amount. To interpret this decline, it is useful to recall that the value of the stock market is equal to the sum of the discounted value of all future dividends. Hence, the drop is as though investors have revised downward their estimate of future profits by as much as 30 percent. However, most of the variation in the value of the stock market is due to changes in expected returns, which are used to discount future cash flows, and not to revisions in expected future growth rates. This insight brings good and bad news. The good news is that investors’ expectations did not decline as dramatically as the drop suggests. The bad news, however, is that we learn little about growth expectations by studying the stock market.
In a research paper released this March, we use data from a related market, namely dividend futures, to obtain estimates of growth expectations by maturity. Dividend futures are contracts that only pay the dividends of the aggregate stock market in a given year. In the absence of arbitrage, if we sum the price of all the dividend claims, they add to the price of the overall market.
There are two important reasons that data on dividend-futures prices are informative. First, dividend futures have historically been good forecasters of economic growth. Second, dividend futures are differentiated by maturity, just like nominal and real bonds. We use this feature of the data to provide an estimate of expected growth over the next year and to obtain a lower bound on the term structure of growth expectations by maturity.
Gormsen and Koijen, 2020
Gormsen and Koijen, 2020
The charts above show the dynamics of dividend- and GDP-growth expectations in the EU and in the US until March 18. Growth expectations did not respond much to the Wuhan, China, lockdown, but they deteriorated following the lockdown in Italy. The US travel restrictions on visitors from the EU led to a sharp deterioration of growth expectations, which occurred again following the declaration of a US national emergency and the subsequent actions by the Federal Reserve on March 15. As of March 18, dividend growth over the next year is down by 28 percent for the S&P 500 and 25 percent for the Euro Stoxx 50. The estimate of GDP growth over the next year is down by 2.6 percent in both the US and the EU.
As a word of caution, we emphasize that these estimates are based on a forecasting model using historical data. In turbulent and unprecedented times, there is a risk that the historical relation between growth and asset prices breaks down, meaning these estimates come with uncertainty.
Gormsen and Koijen, 2020
We also derive a lower bound on expected dividend growth by horizon, which we compute directly using observed prices. The lower bound is forward looking and requires neither a forecasting model nor historical data, which makes it useful in our setting, and only relies on the assumption that expected excess returns have increased. It is plotted in the figure above (see "Expectations over the next decade for dividend growth"). The figure has the lower bound on the change in expected dividends on the vertical axis and the horizon on the horizontal axis. As of March 18, the lower bound is lowest on the two-to-three-year horizon, where dividend growth rates have been revised down by as much as 43 percent in the US and 50 percent in the EU, compared with January 15. Looking at longer horizons, we see signs of catch-up growth.
As of March 18, the lower bound on dividend growth is as low as what we observed during November 2008 of the 2008–09 global financial crisis—at least on the short end. On the long end, the lower bound is still not as low as what we observed during the crisis, potentially indicating that investors expect the current crisis to be shorter.
As the crisis unfolds, we will update the estimates reported regularly on the website: voices.uchicago.edu/gormsen/gdp-growth-forecasts-from-dividend-futures.
Niels Gormsen is Neubauer Family Assistant Professor of Finance and Asness Junior Faculty Fellow at Chicago Booth.
Ralph S. J. Koijen is AQR Capital Management Professor of Finance and Fama Faculty Fellow at Chicago Booth.
Niels Gormsen and Ralph S. J. Koijen, “Coronavirus: Impact on Stock Prices and Growth Expectations,” Working paper, March 2020.
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