WASHINGTON • Investors were pleased on Wednesday when Federal Reserve chairman Janet Yellen said that weakening stock prices pose a risk to the economy, convincing them that she won't rush into more interest rate hikes.
But how should everyone else feel with stocks down 10 per cent in a year?
While far from definitive, evidence exists that equity prices hold clues to the economy, either portending or influencing future growth.
A study by the research firm CXO Advisory Group in 2014 found that changes in gross domestic product only "very slightly" forecast the Standard & Poor's 500 Index over the next few quarters, while stock signals for the economy are more robust.
Dr Yellen's testimony before the US Congress addressed the possibility that markets might contribute to a contraction rather than simply signal one. While acknowledging that rising volatility may reflect "fears of recession risk", her prepared remarks noted that swings in stocks and currency could themselves "weigh on the outlook for economic activity and the labour market", particularly if they persist.
University of California economics professor Roger Farmer said in an interview: "The stock market... is not like the weather forecast - it's like the cigarette butt in the forest. If the stock market drops by 10 per cent, you could expect the unemployment rate to be 3 percentage points higher than it would've been in the absence of the drop."
Dr Yellen during her report to the US Congress this week. She spoke of the possibility that markets might contribute to a contraction rather than simply signal one. PHOTO: BLOOMBERG Here are three ways that declines in stock prices could influence economic growth:
WEALTH
Almost US$3 trillion (S$4.2 trillion) in value has been erased from American shares since the start of the year, a loss of wealth that economists say could sour consumer sentiment and make Americans less likely to spend.
The threat is arguably greater now - with business investment falling in the wake of the commodity rout, pressure has been mounting that consumers would fill in the expansion void.
Americans have a lot of money in the market. As of last September, households had US$17.1 trillion invested in stocks, representing 35.5 per cent of their financial assets, Federal Reserve data compiled by Ned Davis Research shows.
"If you get significant swings in stock averages, it will affect wealth and spending decisions," said Mr Alan Gayle, a strategist at Ridgeworth Investments. "Consumer confidence tends to rise when the stock market is up, and it tends to ease off when it's down."
CORPORATE FINANCE
The seven-year bull market that began when global equity markets bottomed in March 2009 has been a boon to companies trying to raise money in equities. Between initial public offerings (IPOs) and share sales, more than US$1.7 trillion of stock has been sold.
This year's volatility is squeezing off the spigot. January was the slowest month for IPOs since December 2008, when no companies filed after the bankruptcy of Lehman Brothers. In January 2015, 19 companies listed on American exchanges.
FINANCIAL INDUSTRY
Volatility in markets can make life difficult for financial institutions. Look at the performance of bank stocks, which have plunged twice as fast as the S&P 500 this year.
About 8.2 million people, or 5.7 per cent of the US workforce, hold jobs in the broader financial industry, including insurance and real estate. Hiring has increased in this sector for the past 29 months, although it remains 2.2 per cent below its November 2006 peak.
"Layoffs would make an impact if banks cut a big chunk out of the mergers and acquisitions department, or a big chunk out of trading, or a big chunk out of other capital market-sensitive areas,"said Mr John Canally, chief economic strategist at LPL Financial in Boston. "It would put a chill on geographical areas like London and New York that are important financial centres."
BLOOMBERG
