The impact of economic sentiment on European stock markets

Objective: This article aims to analyse the impact of sentiment indicators reflecting the condition of major economies on the returns and volatility of European developed, emerging, and frontier stock markets. Research Design & Methods: We employed survey-based economic sentiment indicators, classified into forward-looking measures reflecting economic expectations and measures of current economic sentiment. We used survey-based economic sentiment indicators, namely the ZEW Economic Sentiment Index for Germany, the ZEW Economic Sentiment Index for the Eurozone, the ZEW Current Condition Index for the Eurozone and the Michigan Consumer Sentiment Index from the US. We modelled the daily stock returns for 27 markets over the period 2008-2022 using a GJR-GARCH model and a time-varying transition probability Markov switching model (TVPMS), where transition probabilities depend on lagged economic sentiment indicators. Findings: The results from the GJR-GARCH model show that economic sentiment generally affects returns and their volatility. We observed the causal relationship between sentiment and returns for different types of markets. These results confirm that sentiment indicators in major economies have a global impact, affecting not only developed markets but also emerging and frontier markets. In addition to the GJR-GARCH methodology, the use of the TVPMS approach confirms the results and provides new insights. We found two market states: high and low volatility, and documented the impact of sentiment on market returns as a function of these states. The Michigan consumer sentiment index had the most substantial and persistent effect on European markets, with significant effects on volatility in both high- and low-volatility states; the ZEW economic sentiment indices affect volatility in high-volatility states, while the ZEW current situation index has a significant effect on volatility only in low-volatility states. Implications & Recommendations: These findings provide investors and financial managers with valuable insights into the influence of different sentiment indicators on decision-making in various market conditions. During periods of high volatility, sentiment based on economic expectations can help to mitigate market fluctuations. In contrast, during stable periods, sentiment reflecting the current economic state is more informative. The U.S. Michigan Consumer Sentiment Index (MCSI) is particularly relevant in this regard, offering meaningful guidance about investment decisions in both stable and volatile environments. The influence of the same sentiment indicators on various European stock markets highlights the region’s strong interconnections and suggests the presence of sentiment contagion. Contribution & Value Added: This study makes an original contribution by combining two well-established models in a novel way. The GJR-GARCH model enables us to analyse the impact of economic sentiment on expected returns and conditional volatility, while the TVP-MS model identifies periods when sentiment exerts its greatest influence. Our research demonstrates that market behaviour responds differently to sentiment indicators, depending on their nature and the volatility regime.