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Bear market to the rescue

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Good Morning. In response to Friday’s letter on the continued strength of the U.S. economy – outside the housing market – a reader noted a clear point, one that we should have raised ourselves. The resilience of the economy, even though it sounds like good news, is going to make the Fed’s job much harder. He may have to tighten very aggressively to bring demand below supply. But the Fed can hope for help from the markets, as we discuss today. Send us an email: robert.armstrong@ft.com and ethan.wu@ft.com.

Wealth effects

The bear market in risky assets was caused, in part, for fear of a recession caused by the Fed. But causality can also work in the other direction: if there is a recession, the bear market will probably be one of the factors.

Lower stock, bond and crypto prices make people feel poorer, so they spend less, making the economy smaller than it used to be. For the Fed, right now, this is welcome news. They need growth to slow down. But for some wealth impact. Can they expect? Can they get more help than they want?

Desmond Lachman, an economist and fellow at the American Enterprise Institute, noted this in response to last week’s letter on the economic downturn:

A 25% stock market shift caused about $ 10 billion in U.S. household wealth to evaporate. In addition, at least $ 3 billion in bonds and $ 2 billion in cryptocurrency wealth were written off as a result of the slump in those markets. . . Assuming the Federal Reserve uses the assumption that a continuous destruction of $ 1 in wealth leads to a 4 cents drop in consumption, if it continues, the recent loss in wealth could reduce consumption by almost 3 percentage points of GDP.

This last number seems pretty big to me, so I tried to recover it. Here’s what I found:

  • According to a division of the Federal Reserve AccountsU.S. households held $ 42.2 billion in mutual fund stocks and shares as of the end of 2021.

  • The Wilshire 5000, an index that occupies almost all shares traded on the US stock market, has fallen 25% since the end of 2021 – a moment that I am happy to almost exactly coincide with the market peak. Thus, in the simplistic assumptions that (a) Americans are primarily exposed to U.S. equities (b) Americans receive their bond exposure through mutual funds, and (c) yields on this bond exposure have roughly followed term bonds Long, we can assume that household investment portfolios lost $ 10.6 billion in value this year.

  • A Newspaper The Federal Reserve, which looks at fluctuations in wealth and household spending during the market boom of the 1990s, finds that “groups of families whose portfolios were most strengthened by exceptional stock market performance in the second half of the 1990s are those groups whose net cash flows.” In the sharpest form from 1995 to 2000 “, and that” e [resulting] “Movements in capital and savings are in line with the effect of wealth in the range of 3-1 / 2 to 5 cents on the dollar, applicable to all families in the economy.”

  • So let’s say, conservatively, that every dollar lost in the markets translates into 3.5 cents of lost spending. That comes to $ 370 billion in lost spending, or about 2.6% of consumer spending or 1.8% of GDP.

  • The total market value of crypto assets fell from $ 2.9 billion to $ 835 billion, according to CoinMarketCap. That translates into another $ 73 billion in lost expenses, plus another third of GDP.

  • So for a first and conservative estimate, the impact of the bear market on spending may amount to a 2 percent drag in GDP.

It is much! Recall that in the first quarter, GDP grew by 2.6 percent, after some of the strange fluctuations in inventory and net imports were erased. How much negative wealth effect is built into these predictions that I have I have no idea.

However, this is a rough and very prepared assessment. The sensitivity of spending to wealth loss probably depends on psychological factors that are difficult to measure. For example, it must matter how many people trust the wealth they have accumulated in the markets, as opposed to thinking of it as a back wind. Did households treat their sudden crypto profits as “money found” rather than savings that they earned hard, and therefore changed their spending patterns less in response to their emergence and evaporation?

About 20 years ago, Fed CEO Edward Gremelich noted that in theory, the impact of stock market wealth on consumption should depend on whether stock prices have risen because earnings have risen, or because capitalization rates have fallen (or what it amounts to Same thing, price / profit multipliers went up):

Suppose, for example, that stock prices rise due to an increase in expected earnings, suppose a jump in productivity. A single household holding shares will have higher wealth and will want to consume more, just as predicted by the wealth effect. . .

[if instead] Stock prices are rising because households are applying a lower discount rate to future earnings [then whether] A single household will want to consume more obscure in this case. Intuitively, households simply deduct the same stream of profits at a different rate; So it is not clear that they are really better and need to increase their consumption.

I would understand this point intuitively as follows. If my stock has risen because of strong economic growth, the gains make sense to me. I own a growing business in a growing economy. If they go up because of multiple expansions, it feels like a chance. I trust less in the new wealth, and may be less inclined to let it change my spending patterns, as a result.

I’m really not sure if the source of refunds in the market is important for expenses or not. But this is a particularly important question at the moment.

During the 2009-2021 bull market, the S&P 500 rose 325% (if you use the end of 2009 as a starting point). Profits during the period grew by 192%. The rest of the profit was caused as a result of a price / profit ratio that increased from 16 to 24. Much of the recent rise has been repaid (the index now stands at 18 times the trailing gains), even with the gains remaining there, for now. How will household spending patterns respond to a change in value without much change in profits?

One good read

If you are reading this newsletter, chances are you care about the Fed. But most people do not. Can it material For inflation expectations?

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