When Market Ills Make the Economy Sick
(Bloomberg) -- We know Jerome Powell’s view. “A little bit of volatility” won’t crater the economy. But as each day passes and the sell-off in stocks deepens, a question gets louder: What about a lot?
It was just Wednesday that the Federal Reserve chairman played down the role of market turmoil in setting monetary policy. Traders responded by giving him more. About $1 trillion has been erased from U.S. equities this week, pushing volatility to a 10-month high. The cycle highlights a risk: one day, a virus Powell views as being quarantined to markets ends up sickening everyone.
“When you see it in the media -- triple-digit declines in the Dow on a regular basis -- at some point it starts to impact consumer psychology and cause people to hold back,” said Jennifer Lee, senior economist at Bank of Montreal.
More than just a signal for growth, markets are capable of becoming an economic force unto themselves. Snowballing losses can cut consumer sentiment, raise borrowing costs and check business confidence. As the central bank ratchets up interest rates and shrinks its balance sheet, a debate picks up over how long the economy can remain immune from the influence of spiraling asset prices.
As of Wednesday, Powell was sanguine. Stocks may feel scary in the present, but “that doesn’t mean it will come into the real data in a big way, or that financial conditions will tighten further.” Many on Wall Street make the same point. As bad as the swings have felt, the S&P 500 Index is down about 8 percent in 2018 -- a long way from its worst year.
The trouble is if it keeps going. History is replete with examples of markets forcing policy makers to take actions they didn’t anticipate. The Fed was famously slow in 2007 to respond to escalating stress in bank funding, claiming for a time that inflation was the biggest risk, before it changed course. Earlier that decade, the Bush administration took office forswearing bailouts for emerging markets, only to then help organize rescues for Argentina, Brazil and Turkey after their currencies and bonds plunged, threatening wider contagion.
More recently in 2016, the Fed was “not early enough in identifying the risks to financial conditions,” Yianos Kontopoulos, global head of macro strategy at UBS Group AG, told clients in a report today. “Ultimately, it was a large tightening in financial conditions that forced a Fed pause.”
For Peter Hooper, chief economist at Deutsche Bank Securities, and other economists, the woes, as bad as they’ve been, haven’t reached the point where they’ll meaningfully dent the outlook for growth. But that doesn’t mean they never will.
“If this trend continues into a serious bear market, a 20 percent to 25 percent drop for stocks, it’s not necessarily moving us right into recession, but it obviously tightens financial conditions,” Hooper said. After Thursday’s 1.6 percent drop, the S&P 500 sits about 16 percent from its September record.
After incorporating recent moves in markets into Bank of America Merrill Lynch’s recession models, they’re now “flashing yellow,” according to economists at the firm including Michelle Meyer. And although a full-blown downturn remains unlikely for now, some indicators show that the probability of a recession has increased.
Stock market drops can poison the economy in two ways. First, by simply reducing household wealth on paper. Even when that doesn’t dent incomes, it can cause people to trim spending -- reducing revenue for companies. And businesses facing higher financing and refinancing costs might also cancel investment plans or even trim headcount to maintain profitability.
As Powell himself has noted, financial conditions, including equity and bond market prices, have tightened this year as markets have tumbled, but they’re still not seen as restrictive. Fed officials remain optimistic about the economy, lowering their forecast for next year to a still-solid 2.3 percent.
Turbulence in markets reflects a souring mood among business people and investors about growth, possibly influenced by concern about trade tensions, but neither that nor existing volatility are at a point where an economic impact is assured, Powell said. “The large effects would have to come from financial-market changes or losses of business confidence, and those are very difficult things to model,” he said at Wednesday’s press conference.
Veneta Dimitrova, senior U.S. economist for Ned Davis Research, estimates that a 10 percent decline in inflation-adjusted household financial wealth in one period subtracts about 0.5 percent from real consumption growth in the subsequent period. Then there’s the psychological fallout from a market swoon that can affect people and firms not directly exposed to price movements in equity or debt.
That’s why economists keep an eye on gauges that track consumer and business confidence.
Consumer confidence and stocks are both whipped around by views on the economy, and the correlation between the two is notable. A mathematical process for calculating how much one set of data influences another shows that nearly half the percent changes in the sentiment gauge are explained by swings in stock prices over an annual basis.
At the moment, two closely watched measures remain strong. The University of Michigan Consumer Sentiment Index and the NFIB Small Business Optimism Index are not far off 10-year highs.
That’s no surprise, says BMO’s Lee, considering that the labor market continues to add jobs at a solid pace, with the unemployment rate at a 49-year low.
Still, the Fed needs to tread carefully and consider the possibility that investors are picking up signals of underlying weakness that haven’t yet showed up in the data. For Christopher Low, chief economist at FTN Financial, the Fed chairman was too dismissive of that risk on Wednesday.
“Market prices have meaning, reflecting supply and demand shifts realized and anticipated,” Low wrote in a note to clients Thursday. “Powell’s insistence that it’s just the stock market, and his implication that equity values are meaningless beyond their impact on wealth and future spending, smacks of denial.”
The S&P 500 Index of U.S. stocks is down 15 percent this quarter, on pace for its worst period since 2008. It’s clearly weighed down by the fading of fiscal stimulus in the U.S., a tightening Fed, slowing growth abroad and trade tensions.
Yet many U.S. indicators continue to reflect underlying economic strength. According to Mayank Seksaria, chief macro strategist at Macro Risk Advisors, markets are divorced from the economy.
He plots the S&P 500 against the Institute for Supply Management Manufacturing PMI -- which, standing above 59, still fits strongly in growth territory. The comparison shows the equity market is the most disconnected from the economy in 30 years.
So, who’s got it wrong?
“There’s an expression from the market that the price action gets it before the data,” said Quincy Krosby, chief market strategist at Prudential Financial Inc. “The big question really is, is this just a slowdown or is it something more dire such as a recession in the offing?”
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