“The economy and markets are intertwined. A sharp drop in the stock market will impact economic activity. They are all in the same bed together,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.
The risk is that the market’s turmoil spills over into the real economy, erasing trillions of dollars in household wealth.
“There is a real threat to Main Street. The Fed is trying to raise rates to ease inflation, but not choke off economic growth. It’s a very fine balance,” said Kristina Hooper, chief global market strategist at Invesco.
At the same time, market stress can make it harder for companies to raise money in capital markets that had been wide-open until very recently.
“A sustained selloff in the stock market starts to catch people’s attention and does affect confidence over time,” said Ethan Harris, head of global economics at Bank of America. “The average person judges the economy by a few statistics. One of them is the Dow Jones Industrial Average.”
Americans are more exposed to market turmoil today
It’s true that the fortunes of the rich are more closely tied to the stock market than the middle class, whose wealth is linked more to home values, which are way up during Covid.
Yet stocks represent a greater chunk of the average American’s net worth than they used to.
Households in the 50% to 90% wealth range held $4.3 trillion in stocks and mutual funds as of last year, representing 9.4% of their net worth, according to the Fed. That’s up from just $1.6 trillion and 6.4% a decade ago. In 1991, stocks made up just 4.7% of this group’s wealth.
Likewise, the bottom 50% of US households held $260 billion in stocks and mutual funds, comprising 2.9% of their wealth. That’s up from $90 billion and 1.8% of their wealth a decade ago.
Asked about the recent market drop, a White House official told CNN the administration focuses on trends in the economy, not any single indicator. The official pointed to “real progress” demonstrated by the 3.9% unemployment rate and jobless claims that have declined by about two-thirds from a year ago, when the unemployment rate was 6.4%.
Economists are on high alert for signs that the stock market stress is infecting the broader capital markets that keep the economy humming.
Yields in the junk bond market have begun to creep higher. A spike would make it more expensive or impractical for leveraged companies to refinance their debt. And that would have a real and immediate economic impact.
Markets have been ‘quite complacent’
The good news is that stocks haven’t yet fallen sharply enough to alarm economists.
The S&P 500 is flirting with a 10% correction from prior highs. Such drops are viewed as healthy after sharp rallies.
“What would make us nervous would be a 15% to 20% drop in markets that is sustained,” said Bank of America’s Harris.
The S&P 500 is nowhere near the 20% threshold required to be considered a bear market, although the Nasdaq got close to that on Monday before rebounding.
“We’ve got a long way to go. I don’t think it’s impossible though,” said Harris. “Clearly, the markets have been quite complacent about the Fed. And the Fed has contributed to that by downplaying the risks and describing inflation as transitory.”
That did not set well with investors, who have become accustomed to unprecedented support from the Fed. Near-zero rates, combined with massive Fed purchases of bonds, forced investors to bet on risky assets like stocks. Now, the reverse is happening.
“The Fed is in an impossible spot, one that they put themselves in,” said Boockvar. “They are the architects of this relationship. Now they have to deal with the so-called break-up.”
Why the Fed isn’t freaking out
Fed officials, gathering for this week’s regularly scheduled policy meeting, are likely not freaking out about the market turmoil. At least not yet.
Mark Zandi, chief economist at Moody’s Analytics, said the market retreat is a feature, not a bug, of the Fed’s shift to inflation-fighting mode.
“So far, I view this as therapeutic,” Zandi told CNN. “The Federal Reserve wants and needs the economy to cool off, otherwise it will blow past full employment and inflation will become a persistent problem.”
Keep in mind that the Fed regularly speeds up and slows down the real economy in large part by influencing financial markets. Lowering rates supports growth by making it easy to borrow and boosting risky assets. And vice versa.
Despite the recent losses, markets remain significantly higher during the Covid era. Even at Monday’s intraday low of 4,222, the S&P 500 was trading 93% above its low in March 2020 when the nation began shutting down.
To be sure, stocks can’t go straight up forever. A recalibration makes sense given the Fed’s shift in its policy.
“The market got ahead of itself. It got overvalued, bordering on frothy,” said Zandi. “As rates rise, bubbles are coming out.” But he added that a 20% to 25% decline in stocks would become more problematic for the real economy.
“That could cause damage that you don’t want to see,” Zandi aded. “It’s tricky because the market can take on a life of its own.”