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More sure-footed stock markets needed to undergird business confidence (Richard Drew/AP)
More sure-footed stock markets needed to undergird business confidence (Richard Drew/AP)

More sure-footed stock markets would help undergird business confidence Add to ...

New Bank of Canada Governor Stephen Poloz last week identified business “confidence” as a key missing ingredient for the next stage of economic expansion in Canada. He preached patience in waiting for companies to feel comfortable enough in the Canadian economy and export markets that they are willing to invest again, to increase capacity and expand output.

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Patience is all well and good – though a pretty nebulous concept for numbers-driven economy watchers. Allow me to identify a more measurable ingredient that has gone AWOL in this quest for confidence: the stock market.

Stocks are in the midst of their worst month in more than a year, with the S&P/TSX composite down almost 5 per cent for the month to date. Canada’s benchmark equity index has suffered three triple-digit declines in the past two weeks, including last Thursday’s nasty 300-point slump.

Now, traditional logic is that improved business confidence is a precursor for rising stock markets – because, the thinking goes (and as Mr. Poloz was saying last week), confidence leads to investment and expansion; growing businesses lead to higher values for those businesses’ stocks. If you prefer to look at it on a more straightforward level, companies tend to get confident when they see signs of rising demand for their products – ground-level evidence of economic growth that typically translates to strong stock markets. Either way, confidence and strength in stocks would seem to go together.

Indeed, the statistics bear this out: Confidence indicators and stock indexes typically move in the same direction. However, there’s evidence that the traditional thinking has the cause-and-effect relationship backward.

“Business confidence surveys are not a predictor of stock market performance, but rather stock market performance is a predictor of business confidence surveys,” concluded University of Cape Town economist Daryl L. Collins in a 2001 study on the topic.

Similarly, analysis of the data over the past couple of decades indicates that consumer confidence indexes – which are calculated based on consumer survey questions about current economic conditions and future expectations – also seem to follow movements in the stock market, rather than the other way around.

Note that this is pretty carefully worded: Stock-market direction seems to influence the results of confidence surveys . The question is whether the surveys actually measure what they intend to measure, that is, actual confidence among consumers and business managers.

“To most Americans, these [survey] questions are too abstract,” wrote financial researcher and newsletter publisher James Bianco, in a post last year on financial commentator Barry Ritholz’s popular The Big Picture blog site. “It is like asking them, ‘What is the weather in the United States and what do you expect the weather of the United States to be?’ How does one answer this? You would probably look out the window and describe what you see.”

And what people see, he argued, is the news on the movements of the stock market, which are there (like the weather) every day.

Still, we can’t discount that those market gyrations do affect people’s perceptions of the broader economy’s health – and that tumbling markets can rattle, even shatter, those perceptions. It makes intuitive sense that stock market slumps could, indeed do, weigh on consumer and business confidence – not just on the indexes that purport to measure said confidence.

Mr. Poloz told reporters last week that he has a more concrete way of identifying the return of business confidence: When he actually sees “a pick-up in the rate at which new companies are formed.” He argued that the willingness to launch businesses from scratch is a strong signal in belief that demand is back.

“It requires a bigger decision ... So it’s taking longer,” he said.

Unstable and uncertain financial markets certainly won’t make those decisions – or the decisions of existing businesses to expand production – any easier. If Canadian businesses needed another reason to question the recovery and whether they should start investing again, the market’s newest slump has provided one. Unless stocks can find their footing, the confidence recovery that Mr. Poloz is waiting for may well be taking a step backward.

 

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