In today's environment, the notion that the stock market isn't the economy doesn't hold up anymore
- Due to a number of factors, the fates of Wall Street and Main Street have never been so intertwined.
- The share of household wealth that comes from directly or indirectly held stocks hit a record 41.9%, more than double where it was 30 years ago.
- Tech companies also rely on their share prices to help raise capital to pay for innovation.
- Fed officials, though, might not mind seeing some of the froth come out of Wall Street as it seeks to curtail inflation.
The stock market may not literally be the economy, but the distinction between the two is getting increasingly harder to draw.
With household ownership of stocks scaling new heights and the destiny of companies — particularly in the innovative tech sector — 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 sending a particularly good sign for the broader growth outlook.
"In the last 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 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 all of the economy, but it's also hard to dispute the notion that it's become a larger part of everyday life.
Through the end of 2021, the share of household wealth that comes from directly 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, has made U.S. equities an attractive place to park money and earn nice returns.
It's also made the economy much more susceptible to shocks on Wall Street.
"When risk assets fall and fall fast enough, there's no question they're going to hurt growth," said LaVorgna, who was chief economist for the National Economic Council under former President Donald Trump. "If anything, the relationship is even better when asset prices decline than when they go up."
How it works
The transmission mechanism between the market and economic growth is multipronged but fairly simple.
Stocks and consumer confidence historically have been linked closely, 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 less wealth on consumer balance sheets.
There's also another important point: Companies, particularly innovation-heavy Silicon Valley firms, constantly need to raise capital and look to growth in their stock prices to do so.
"In addition to the wealth effect on consumers, [the market] does affect investment decisions by companies, particularly the high-growth companies, the tech companies, that rely on raising capital through the equity market to finance their growth," said Mark Zandi, chief economist at Moody's Analytics.
"If stock prices are down, it's much more difficult to raise equity. Their cost of capital is also a lot higher, therefore they're not going to be able to expand as aggressively," he added. "That's another element of the line between what's happening in the equity market and economic growth."
If revenue growth gets weak enough, companies then have to find a way to cut costs to make their bottom-line numbers.
The first place they usually look: payrolls.
Employment has been rising at a steady pace over the past two years, but that can come to an end if the current market tumult persists.
"Companies manage their share price, and they want to make sure those projections remain intact as best they can maneuver that," said Quincy Krosby, chief equity strategist at LPL Financial. "If need be, they will bring costs down. For most companies, their main cost of capital is labor. That's another reason why the Fed has to watch this."
Where the Fed fits in
Indeed, the Federal Reserve is a major component as well in the link between the markets and the economy.
Central bankers always have been attuned to market gyrations, but following the 2008 financial crisis, monetary policy has even more so relied on risk 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 maintain the movement of cash through the economy, and that includes the financial economy.
"Consumers are extraordinarily involved in the equity market, and the Fed has put them there," said Steve Blitz, chief U.S. economist at TS Lombard. "Consumers have been big buyers of equities ever since 2016, in particular. We've seen a really big correlation between equity prices and discretionary spending."
Fed officials, though, might not mind seeing some of the froth come out of Wall Street.
For the central bank, inflation remains its main problem, and that has come from supply that has been unable to meet with relentless consumer demand for goods over services. Markets have been in sell-off mode since Thursday, the day after the Fed announced a 50-basis-point rate increase that was the biggest hike in 22 years.
The Fed also is going to start shedding some of those bonds it has accumulated, another process that directly affects Wall Street but also finds its way to 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 the market pulls back, the assumption is it can help curtail demand, which is one of the things they want. They want to slow the economy."
Still, Zandi, the Moody's economist, cautions against letting the current downturn in which the S&P 500 has tumbled about 15% year to date send too strong a signal about a recession ahead.
GDP dropped at a 1.4% pace in the first quarter, but most Wall Street economists see stronger growth through the end of the year, if nowhere near the big gains of 2021.
"The market is a prescient indicator of where the economy is headed, but overstates the case generally," Zandi said. "So the sell-off we're seeing now strongly argues for a slowly growing economy, perhaps an economy that's flirting with recession. But it's probably getting ahead of itself in that regard."