Abstract
This study examines whether stock market illiquidity forecasts real UK GDP growth using data over the period 1989q1-2012q2. Apart from standard linear model specifications, we also utilize non-linear models, which allow for regime switching behavior in terms of a liquid versus an illiquid market regime and over the phases of the business cycle. Our findings support a statistically significant negative relationship between stock market illiquidity and future UK GDP growth over and above the usual control variables. This relationship is found to be stronger during periods of highly illiquid market conditions and weak economic growth. Our out-of-sample forecasting analysis indicates that a regime-switching model of illiquid versus liquid market conditions predicts UK growth better than any other model. Actually, this model is the only one to significantly outperform the GDP growth forecasts published in the Bank of England’s Inflation Report.
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