The New York Stock Exchange (NYSE) at the New York Stock Exchange (NYSE) near the Wall Street subway station on Monday. Rev. 3, 2022.
Michael Nagle | Bloomberg | Getty Images
The stock market may not be the economy, but the distinction between the two is getting harder to draw.
With new heights and destiny, companies – especially in the innovative tech sector – have tied to their share prices, the Fates of Wall Street and Main Street have never been so intertwined.
So as the stock market goes through this volatile period, it’s not a good sign of a broader growth outlook.
“In the last 20 years, we’ve had a financial economy that has grown,” said Joseph LaVorgna, chief economist at Natixis. “You could have argued a few years ago that the stock market was not the economy, and that was very accurate. That is no longer the case today.”
No one would argue that the stock market is the economy of all, but it’s also a hard part to dispose of.
By the end of 2021, the share of household wealth that comes from direct or indirectly held stocks hit a record 41.9%, more than double where 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 to a lackluster global economy, have made US equities an attractive place to park money and earnings good returns.
Wall Street on shocks to make the economy more susceptible.
“When risk assets fall and fall fast enough, there’s no question they’re going to hurt growth,” said LaVorgna, who was the chief economist under former National Economic Council President Donald Trump. “If anything, the relationship is even better. When the asset prices decline, they go up.”
How it works
The transmission mechanism between the market and economic growth is multi-pronged but rather simple.
Stocks and consumer confidence have historically been linked, so when stocks fall people tend to curtail spending. The decline in spending slows sales growth and makes share prices less attractive when compared to future earnings. In turn, that triggers a market reaction that spills back into consumer wealth sheets.
There’s also another important point: companies, especially innovation-heavy Silicon Valley companies, need to raise capital and look for growth in their stock prices.
“In addition to the wealth effect on consumers, [the market] “Investment is made by companies, mostly high-growth companies, and tech companies, that rely on raising capital to finance their growth,” said Mark Zandi, chief economist at Moody’s Analytics.
“If stock prices are down, it’s more difficult to raise equity. Their cost of capital is also a lot higher, so they’re not going to be able to expand as aggressively,” he added. “That’s another element of what’s happening in the line between equity markets and economic growth.”
If revenue growth gets weak enough, companies will then have to find a way to cut costs to their bottom-line numbers.
The first place they usually look: payrolls.
Employment has been rising at a steady pace for the past two years, but that could come to an end if the current market tumult persists.
“Companies manage their share price and they want to make sure that those projections remain intact as best they can,” said Quincy Krosby, chief equity strategist at LPL Financial. “If they need to, they will bring down costs. For most companies, their main cost of capital is labor. That’s another reason why the Fed has to watch this.”
Where in the Fed Fits
In fact, the Federal Reserve is a major component of a well-placed link between the markets and the economy.
Central bankers have always had market gyrations, but following the 2008 financial crisis, monetary policy has become even more reliant on risky assets. The Fed has purchased more than $ 8 trillion in bonds since then, and it has kept the economy at bay.
“Consumers are extraordinarily involved in the equity market, and the Fed has put them there,” said Steve Blitz, chief US economist at TS Lombard. “Consumers have been having big buyers’ equities ever since. In 2016, we’ve seen a really big correlation between equity prices and discretionary spending.”
Fed officials, though, might not have seen much of the froth come out of Wall Street.
For the central bank, its main problem with inflation remains, and that has come from the supply of services that meet the relentless consumer demand. Markets have been in sell-off mode since Thursday, the day after the Fed announced a 50-basis-point rate hike in 22 years.
The Fed is also going to start shedding some of those bonds that it has accumulated, another process that directly affects Wall Street but also finds its way to 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 the market pulls back, the assumption is that it can help curtail demand, which is one of the things they want. They want to slow down the economy.”
Still, Zandi, the Moody’s economist, cautions against letting the current downturn in the S&P 500 have tumbled about 15% year-to-date to send a strong signal about a recession ahead.
GDP dropped at a 1.4% pace in the first quarter, but most Wall Street economists see strong growth as the end of the year, with big gains now nearing 2021.
“The market is a prescient indicator of where the economy is headed, but overstates the case,” Zandi said. “So the sell-off we are seeing now is a slow-growing economy, perhaps an economy that’s flirting with recession. But it’s getting ahead of itself.”