How real is the wealth effect in a bull market?

Despite what you might read or hear, the stock market is not the economy.

But that does not mean you should ignore the effect that the stock market has on household income and spending, the labor market, overall financial conditions and economic growth.

A 2021 paper in the American Economic Review found that an increase in local stock wealth driven by aggregate stock prices will increase local employment and payrolls in nontradable industries. The result is that for every dollar of increased stock market wealth, consumer spending increases by 3.2 cents.

We estimate that the sharp rebound in equities last year contributed to an increase of roughly $900 billion in households’ stock wealth.

Given that the upper quintile of income earners are responsible for roughly half of all spending, this strongly implies an additional tailwind behind overall American household spending.

Using a back-of-the-envelope calculation, we estimate that the sharp rebound in equities last year contributed to an increase of roughly $900 billion in households’ stock wealth, or $288 billion in consumer spending.

If we consider the spending multiplier effect, total spending increase would be much higher at $1.3 trillion. Based on those two numbers, the increase in total spending would account for between 1.1% and 4.8% of nominal gross domestic product, which grew by 6.3% in the entire year.

Given the 6.18% increase in the S&P 500 index this year following the 24.2% increase last year, this is a nontrivial development with respect to the direction of overall economic activity, household income, spending and savings.

Economic resilience and financial optimism

While monetary policy remains sufficiently restrictive, signs of an eventual easing of financial conditions in the second half of the year are on the horizon and are an essential factor in the recent improvement in financial conditions.

The RSM US Financial Conditions Index has improved to 0.13 standard deviations above neutral, which implies that financial markets are neither a drag nor a tailwind to overall growth and is an indication of a strong economy.

But gains in equity markets in general and the valuations of a select number of technology stocks in particular were a tailwind behind spending last year and will most likely be again in the first quarter. These gains are occurring following, and despite, two years of a dramatically tight monetary policy.

RSM US Financial Conditions Index

Our composite financial conditions index includes three factors: The equity market, whose balance of risk and reward is one standard deviation above what would normally be expected; the money market, which is neutral since last April; and the bond market, which remains one standard deviation below normally expected levels of risk and reward.

The Federal Reserve’s 5.25 percentage-point hike in interest rates since March 2022 has dampened overall demand and inflation, while the recent improvement in financial conditions is laying the groundwork for economic growth.

The tight financial conditions that characterized the past two years have eased and we anticipate price moderation in two measures of inflation—the personal consumption expenditures index and the consumer price index—toward the Federal Reserve’s 2% target.

Our forecast on the direction of monetary policy has not changed since we published it in December. We anticipate four 25 basis-point rate cuts that we expect to start in June. Those cuts will also tend to cause an improvement in overall financial conditions and support solid spending by upper-income households.

The reward for high income households

The American Economic Review paper, which examined county-level data, indicates that increased stock wealth leads to increased local spending on nontradable goods, leading to increased employment

Equity returns

This was particularly the case in counties with higher levels of stock market wealth.

Nontradable industries typically include governmental services, education, health care, the construction sector and retail.

In contrast, tradable industries include manufacturing, agricultural production and resource extraction (that is, goods that can be shipped). The paper found no increase in employment in industries that mostly produce tradable goods that were because of equity advances.

Interestingly, the authors’ decomposition of data shows that no single state drove the results and that differences within states were persistent over time.

Fittingly, the authors wrote the main threat to the paper’s causal interpretation of their findings is that high-wealth areas are responding differently to other aggregate variables that co-move with the stock market.

As the findings of the paper suggests, higher-income households with equity-market exposure would have benefited from the unrelenting increases in the stock markets prices.

With interest rates at zero for much of the decade before the pandemic, the stock market was the only game in town, and higher-income households reaped the benefits.

DJIA and home construction

The wealth effect of the equity market was then compounded by the rapid increase in housing prices brought on by the unique circumstances of the pandemic era.

We can see the disparity of returns, not only in the return of tech stocks in the S&P 500 or the Nasdaq index, but also in the performance of the Dow Jones subindex for home construction relative to the Dow Jones Industrial Average. Home-building is a nontradable industry and evidently was a good place to invest last year.

Let’s Talk!

Call us at (325) 677-6251 or fill out the form below and we’ll contact you to discuss your specific situation.

  • Topic Name:
  • Should be Empty:

This article was written by Joseph Brusuelas, Tuan Nguyen and originally appeared on 2024-02-29.
2022 RSM US LLP. All rights reserved.
https://realeconomy.rsmus.com/how-real-is-the-wealth-effect-in-a-bull-market/

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.