A Wall Street subway station near the New York Stock Exchange (NYSE) in New York, on Monday, January 3, 2022.
Michael Nagel | Bloomberg | Getty Images
The stock market may not literally be the economy, but distinguishing between the two is becoming increasingly difficult.
As household stock ownership soars to new heights and the fortunes of companies – particularly in the innovative technology sector – are tied to their stock prices, the fortunes of Wall Street and Main Street have never been more intertwined.
So while the stock market is going through this volatile period, it’s not boding particularly well for the broader growth prospects.
“Over the past 20 years, we’ve had a financial economy that has grown significantly,” said Joseph LaVorgna, chief economist for the Americas at Natixis. “You could have argued a few decades ago that the stock market wasn’t the economy, and that was very true. That is no longer the case today.”
No one would argue that the stock market makes up the entire economy, but it’s also hard to argue that it’s become a bigger part of everyday life.
By the end of 2021, the proportion of household wealth derived from directly or indirectly owned stocks reached a record 41.9%, more than double what it was 30 years ago, according to Federal Reserve data. A variety of factors, from the advent of online trading to stock-friendly monetary policy to a lackluster global economy, have made US stocks an attractive place to invest and earn nice returns.
It has also made the economy much more vulnerable to Wall Street shocks.
“If risky assets fall and fall fast enough, they will undoubtedly 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 are falling than when they are rising.”
How it works
The transmission mechanism between the market and economic growth is complex but relatively simple.
Stocks and consumer confidence have historically been closely linked, so people tend to rein in spending when stocks are falling. The decline in spending is slowing revenue growth and making stock prices less attractive relative to future earnings. This, in turn, triggers a market reaction that translates into less prosperous consumer balance sheets.
There is another important point: companies, especially innovative companies from Silicon Valley, have to constantly raise capital and watch out for rising share prices.
“In addition to the wealth effect on consumers [the market] influences investment decisions of companies, particularly high growth companies, technology companies that rely on raising capital through the stock market to fund their growth,” said Mark Zandi, chief economist at Moody’s Analytics.
“When stock prices fall, it’s much more difficult to raise equity. 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.”
When revenue growth gets weak enough, companies need to find a way to cut costs to stay below the bottom line.
The first place they usually look: payslips.
Employment has been rising steadily over the past two years, but that may end if the current market turmoil continues.
“Companies manage their share price and want to ensure that those projections hold up as best they can,” said Quincy Krosby, chief equity strategist at LPL Financial. “If necessary, they will reduce costs. For most businesses, the primary cost of capital is labor costs. That’s another reason the Fed needs to keep an eye on this.”
Where the Fed fits in
In fact, the Federal Reserve is also an important component in the link between markets and the economy.
Central bankers have always been attuned to market movements, but following the 2008 financial crisis, monetary policy has relied even more on risky assets as a transmission mechanism. The Fed has since bought more than $8 trillion in bonds to keep interest rates low and keep cash moving through the economy, and that includes finance.
“Consumers are extremely involved in the stock market, and the Fed got them there,” said Steve Blitz, chief US economist at TS Lombard. “Consumers have been big buyers of stocks, particularly since 2016. We’ve seen a really big correlation between stock prices and discretionary spending.”
However, Fed officials may not mind if some of the foam comes from Wall Street.
For the central bank, inflation remains its main concern, and that stems from supply having been unable to meet unrelenting consumer demand for goods rather than services. Markets have been in sell-off mode since Thursday, the day after the Fed announced a 50 basis point hike in interest rates, the largest in 22 years.
The Fed will also begin dumping some of its accumulated bonds, another process that affects Wall Street directly but also finds its way to Main Street through higher borrowing costs, particularly on home loans.
The market and the economy “are different, but they’re connected in some places,” Krosby said. The market “is a component of financial conditions, and if the market pulls back, it’s believed that it can help curb demand, which is one of the things they want. They want to slow down the economy.”
Still, Zandi, an economist at Moody’s, warns against taking the current downturn, which has seen the S&P 500 down about 15% year-to-date, as too strong a signal of an imminent recession.
GDP fell 1.4% in the first quarter, but most Wall Street economists see stronger growth through the end of the year, albeit nowhere near the big gains of 2021.
“The market is a forward-looking indicator of where the economy is going, but generally overstates it,” Zandi said. “So the sell-off we’re seeing now speaks strongly to a slow-growing economy, perhaps an economy flirting with recession. But she’s probably overtaking herself in that regard.”