A Wall Street subway station near the New York Stock Exchange (NYSE) in New York on Monday, January 3, 2022.
Michael Nagle | Mayor Bloomberg | fake images
The stock market may not literally be the economy, but the distinction between the two is getting harder to draw.
With household stock ownership scaling new heights and the fate of companies, particularly in the innovative technology sector, tied to their share prices, the fates of Wall Street and Main Street have never been more intertwined.
So as the stock market goes through this volatile period, it’s not sending a particularly good signal for the broader growth outlook.
“Over the last 20 years, we’ve had a financial economy that has grown significantly,” said Joseph LaVorgna, chief economist for the Americas at Natixis. “A few decades ago, you could have argued that the stock market was not the economy, and that was very accurate. That is no longer the case today.”
No one would say that the stock market is the entire economy, but it’s also hard to argue with the idea that it has become a more important part of everyday life.
Through the end of 2021, the share of household wealth that comes from directly or indirectly owned stock hit a record 41.9%, more than double what it was 30 years ago, according to data from the Federal Reserve. A host of factors, from the advent of online trading to stock-friendly monetary policy and a lackluster global economy, have made US stocks an attractive place to deposit money and earn good returns.
It has also made the economy much more susceptible to shocks on Wall Street.
“When risk assets go down and they go down fast enough, there is no question that they are going to hurt growth,” said LaVorgna, who was chief economist at the National Economic Council under former President Donald Trump. “If anything, the relationship is even better when asset prices go down than when they go up.”
How does it work
The transmission mechanism between the market and economic growth is multiple but quite simple.
Historically, stocks and consumer confidence have been closely linked, so when stocks fall, people tend to cut spending. Declining spending slows sales growth and makes stock prices less attractive compared to future earnings. In turn, that triggers a market reaction that translates into less wealth on consumers’ balance sheets.
There’s also another important point: Companies, particularly innovation-heavy Silicon Valley firms, constantly need to raise capital and seek growth in their share prices to do so.
“In addition to the wealth effect on consumers, [the market] It affects the investment decisions of companies, particularly high-growth companies, technology companies, that rely on raising capital through the stock market to finance their growth,” said Mark Zandi, chief economist at Moody’s Analytics. .
“If share prices go down, it’s much harder to raise capital. Their cost of capital is also much higher, so they won’t be able to expand as aggressively,” he added. “That’s another element of the line between what’s happening in the stock market and economic growth.”
If revenue growth weakens enough, companies must find a way to cut costs to achieve their bottom line.
The first place they usually look: payroll.
“Companies manage their share price and want to make sure those projections stay intact to the best of their ability,” said Quincy Krosby, chief equity strategist at LPL Financial. “If necessary, they will cut costs. For most companies, their main cost of capital is labor. That’s another reason the Fed has to keep an eye on this.”
Where does the Fed fit in?
In fact, the Federal Reserve is also an important component in the link between the markets and the economy.
Central bankers have always been attuned to market gyrations, but after the 2008 financial crisis, monetary policy has relied even more heavily on risky assets as a transmission mechanism. The Fed has bought more than $8 trillion in bonds since then in an effort to keep rates low and keep cash moving through the economy, and that includes the financial economy.
“Consumers are extraordinarily involved in the stock market, and the Fed has put them there,” said Steve Blitz, chief US economist at TS Lombard. “Consumers have been big buyers of stocks since 2016, in particular. We’ve seen a really big correlation between stock prices and discretionary spending.”
Still, Fed officials wouldn’t mind seeing some of the froth come off Wall Street.
For the central bank, inflation remains its main problem, and that comes from supply that has failed to meet relentless consumer demand for goods over services. Markets have been in sell-off mode since Thursday, the day after the The Fed announced a 50 basis point rate hike that was the biggest increase in 22 years.
The Fed is also going to start dumping some of those bonds it has accumulated, another process that hits Wall Street directly but also hits Main Street through higher borrowing costs, especially on home loans.
So the market and the economy “are different, but they are joined at points,” Krosby said. The market “is a component of financial conditions, and as it pulls back, it’s supposed to help reduce demand, which is one of the things they want. They want to slow down the economy.”
Still, Zandi, the Moody’s economist, warns against letting the current recession in which the S&P 500 is down about 15% so far this year send too strong a signal about a recession ahead.
GDP fell at a 1.4% pace in the first quarter, but most Wall Street economists expect stronger growth through the end of the year, even if nowhere near the big gains of 2021.
“The market is a prophetic indicator of where the economy is headed, but it generally overstates the case,” Zandi said. “So the sell-off that we’re seeing now is a strong case for a slow-growing economy, maybe an economy that’s flirting with recession. But it’s probably getting ahead of itself in that regard.”
Reference-www.cnbc.com