Stock Market Illiquidity's Predictive Role Over Economic Growth: The Australian Evidence

Abstract

In this paper, I examine the ability of equity market illiquidity to predict Australian macroeconomic variables, between 1976 and 2010. In contrast to existing, U.S.-based, studies, I find that stock market illiquidity does not, on average, have much predictive power over economic growth. Consistent with the weak in-sample predictive power, economic growth forecasts from models that exclude stock illiquidity from the set of explanatory financial variables are statistically no worse than forecasts from models that include illiquidity. However, I find strong evidence that the predictive power of equity market illiquidity is state-contingent, with much higher predictability in states associated with economic and financial stress. The difference between the single-state and regime-switching models' results reflects the fact that, as the nonstressed states have been much more prevalent, parameter estimates from a single-state model averages over both stressed and non-stressed states thus lowering the statistical and economic significance of the estimates.