European equity markets volatility spillover: Destabilizing energy risk is the new normal

• Published date: 01 December 2023
• Author: Zsuzsa R. Huszár,Balázs B. Kotró,Ruth S. K. Tan
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/jfir.12359

Received: 15 October 2023

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Accepted: 23 October 2023

DOI: 10.1111/jfir.12359

ORIGINAL ARTICLE

European equity markets volatility spillover:

Destabilizing energy risk is the new normal

Zsuzsa R. Huszár

1,2

|Balázs B. Kotró

1

|Ruth S. K. Tan

2

1

Finance Institute at Corvinus University of

Budapest

2

Department of Finance at NUS Business

School, at the National University of

Singapore

Correspondence

Zsuzsa R. Huszár, Finance Institute at

Corvinus University of Budapest.

Email: Zsuzsareka.huszar@uni-corvinus.hu

Abstract

While energy risk is increasingly recognized as a systemic

risk, there is limited comprehensive analysis of the risk

propagation in regional contexts. In this study, we examine

oil and natural gas price changes and shocks in relation

to equity market returns and volatility for 24 European

Economic Area (EEA) countries. In addition to traditional

panel regressions, we also deploy the Diebold‐Yilmaz

(2014) spillover index for a closed network analysis. We

differentiate in the cross‐section across the core EU block,

PIIGS countries, EU enlargement countries joining after

2004, and other non‐EU countries, to provide insights into

the ongoing debates on the European energy market

stability. While we find evidence of the manifestation

of energy risk throughout the sample period, we find that

until 2019 the primary sources of volatility spillover in the

EEA economic network arose from economic or political

uncertainty. Energy risks, measured by large crude oil and

natural gas price shocks also significantly contributed to

equity market volatility, with increasing volatility risk arising

from natural gas, a green labelled energy source after 2019.

Last, we show that CEEC equity markets are more sensitive

to oil and natural gas price shocks when domestic

currencies depreciate against the Euro.

JEL CLASSIFICATION

G1, G15, Q4, Q5

J Financ Res. 2023;46:205–271. wileyonlinelibrary.com/journal/JFIR

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© 2023 The Southern Finance Association and the Southwestern Finance Association.

The authors thank conference organizers and participants at the Journal of Financial Research (JFR)‘s 2023 European Symposium in collaboration with

BAFFI CAREFIN Center at Bocconi University in Milan.

1|INTRODUCTION

Oil and natural gas resources are critical for major manufacturing processes and services. This economic and

sometimes political importance of energy markets has motivated a growing energy finance literature in recent

decades (Hamilton, 1983; Herrera et al., 2011; Kilian and Park, 2009; Mensi et al., 2021). The analysis of the impact

of energy prices on economic activity is rather complex as it cannot be considered in isolation without also

considering feedback from economic activity and growth. On the one hand, low energy prices can fuel production,

manufacturing, and investment, which in turn increases demand and eventually energy prices. On the other hand,

while in general high economic growth is associated with high energy demand, energy prices increase is inevitable

due to low short‐term elasticity of supply, potentially resulting in a slowdown in growth. This co‐integrated relation

between the economy and the energy market has been documented in prior studies (e.g., Zhu, Li, and Yu, 2011).

In the new millennium, the complexity and volatility of the energy market increased. First, in 2004, with the

financialization of the commodity market speculators have gained access to the market (Ding et al., 2021). More

recently, additional sources of volatility have emerged from the pandemic, growing political uncertainty (e.g., Russo‐

Ukraine war) and growing cybersecurity threats of oil and gas and utility companies.

1

Overall, recent studies have

recognized energy market risk as a new source of systemic risk attracting much academic, as well as policy

attention.

The first strand of finance—energy market studies primarily examine the influence of energy commodity prices

on equity returns (Andreasson et al., 2016; Dutta et al., 2020; Olson, Vivian, and Wohar, 2014). Their focus varies

from the US market, major oil producing countries, key global equity exchanges, and specific regions or countries,

such as BRICS and China. Kling (1985), Jones and Kaul (1996), and Sadorsky (1999;2001) show that a rise in oil

price leads to a fall in US stock returns, while Sadorsky (2001) finds a positive relation between oil and Canadian

equity prices. There is also evidence of oil prices negatively affecting the equity markets in the Gulf countries (GCC),

which is somewhat trivial given the large contribution of oil export to the GDP (e.g., Arouri et al., 2011b;

Hammoudeh and Aleisa, 2004).

Aloui, Aissa, and Nguyen (2011) find that oil price shocks negatively affect stock markets in various countries,

including the USA, during the Global Financial Crisis. However, there is variation across oil importing and exporting

countries, with oil exporters naturally benefiting from oil price increase (e.g., Ramos and Veiga, 2013). Kang et al.

(2015) document time varying impact of oil shocks on stock returns in the USA. Lin, Fang, and Cheng (2014) report

mixed results from China where oil price increase is often positively associated with market returns. More recently,

Castro (2023) reports consistent evidence of time varying impact of oil price movement on a small sample of

European equity markets.

Besides examining return correlation and lead‐lag relations, an increasing number of studies investigate the

volatility interconnectedness across the commodity markets (including oil) and the equity market. A number of

studies examine the US market (e.g., Arouri et al., 2011a; Phan et al., 2016) and major oil producing countries

(Arouri et al., 2011b). More recently, Dai and Zhu (2022) provide insights into volatility spillover and the dynamic

connectedness of WTI crude oil futures, natural gas futures, in Chinese context. Again, the lack of European

coverage is rather evident, as only a few studies examine European equites or European markets. Zhang et al.

(2020) study the return and volatility spillover of natural gas, crude oil, and electricity utility stock indices in North

America and Europe and show that compared to natural gas, crude oil has a greater volatility spillover on electricity

utility stock indices. Castro, Jiménez‐Rodríguez, and Kizys (2023) also examine the oil price influence on European

equity markets and find time varying impact of oil price movements.

Addressing the time varying interconnectedness of equity end energy markets Mensi et al. (2017) provide an

in‐depth analysis using variational mode decomposition (VMD) method and static and time‐varying symmetric and

1

According to Statista there were 21 attacks on Oil and Gas companies in 2021. A comprehensive list of ransomware attacks on oil and gas, and energy

companies is available on: https://www.oilandgasiq.com/digital-transformation/articles/5-big-cyber-security-attacks-in-oil-and-gas.

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asymmetric copula functions. The authors document evidence of tail dependence and show that the stock market's,

using European, US, and Canadian equity indices (S&P500, STOXX600, DJPI and TSX) respond to oil price (WTI)

change differently in down‐markets and in the cross‐section the responses also vary because of the country's

energy import dependence. The authors suggest that there is increased connectedness because more investors

make decisions not only based on fundamental information in stock markets, but also on prevailing information in

the oil markets. Bradley and Malik (2010) also report time varying effects, and compute volatility persistence by

incorporating endogenously determined structural breaks into a GARCH model, while Salisu and Fasanya (2013)

document structural breaks in oil prices in 1990 and 2008.

Interesting, to our knowledge, there are no comprehensive European market study that analyzes contemporane-

ously a large number of European equity markets in relation to crude oil and natural gas prices, despite the growing

European Energy Crisis (IMF, 2022).TheEuropeanEconomicArea(EEA),withits ambitious net zero emission targets,

has been at the forefront of climate change initiatives for years, albeit with limited success. In 2022, the European

Parliament (European Parliament, 2022) agreed not to veto the designation of nuclear and gas energy sources as green,

as part of its efforts to encourage energy diversification. Due to growing opposition for nuclear energy from the public in

Germany and France (Reuters, 2023), gas as a less “dirty”alternative than oil has been pushed forward across Europe.

Overall European gas demand has been gradually increasing from 1971 to 2017, with declining production in all

countries with the exception of Norway (IOGP, 2018), exposing countries to increasing volatile gas prices, which

resulted in the adaptation of emergency energy regulations in EU in 2022 (European Council, 2022).

This study aims to examine the economic spillover effect of crude oil and natural gas in Europe. While most energy

finance studies focus on oil, we consider the examination of the role of gas increasingly important because of the

increasing reliance on this form of energy in EU countries. Specifically, we examine the implications of price change and

volatility of energy commodities on equity markets across Europe from March 24, 2003, to December 31, 2022,

covering several political and economic turmoil events (e.g., the 2008 Georgian‐Russian war, Crimea Annexation, and

the ongoing Russian‐Ukrainian war (Council of Europe, 2008;2023). In the cross‐section, we include all current and past

(EEA) countries, except for a few countries (e.g., Slovakia, Luxembourg, Iceland, Malta) because of data limitations. Our

final sample, comprising 24 European economies, provides comprehensive coverage for the EEA.

First, in panel regression setting, we examine the equity market performances of the sample countries, using MSCI

index daily returns. We find that crude oil and natural gas prices systematically influence equity markets. We also

examine MSCI index volatility in panel regressions. The results show that oil and gas are major volatility contributors and

have been increasingly so over the years. More importantly, we find that countries with weak or depreciating domestic

currencies are more sensitive to energy shocks. In the final section, we deploy Diebold and Yilmaz (2014;2023)spillover

index (D‐Y index hereafter) to gain more insights into the spillover effect of energy prices in a closed network of

European equity markets, accounting for only volatility transmission and source of volatility within the network.

We provide network analysis for the 2004 EU enlargement, 2005−2008 US Mortgage market run‐up to the

2008 Global Financial Crisis, 2009−2012 European Sovereign Debt Crisis, and other subperiods such as,

2013−2015, 2016−2019, 2020, 2021, and 2022 to provide insights into the impacts of network changes. Across

the eight subperiod analysis, we find significant differences. During our sample period of 20 years, the primary

sources of volatility were initially from economic or political uncertainty. Generally, the key sources of volatility in

the European equity markets arise from a specific country, or group of countries, e.g., from Greece during the

sovereign debt crisis, from Central and Eastern European countries (CEEC) after the 2004 EU extension, and from

Norway during the 2008 oil rout (Jung and Park, 2011).

2

We also note that the volatility spillover effect of oil and

gas is potentially an acute issue to consider.

Overall, our study provides three unique contributions by extending the work of Mensi et al. (2017), in several

directions. Using a comprehensive sample of European equity indices, we document heterogenous implications of

2

There are many oil routs during the last 100 years of history. We specifically refer here to the 2008 oil rout when oil prices declined from $150 to 40 in a

course of 6 months or so. https://capital.com/crude-oil-industry-history-market-trends-trading.

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