Where the stock market goes, the US economy will follow

Perhaps the last time the economy was so dependent on rising asset prices was the housing boom in the mid-2000s, which benefitted a broad swath of households and drove consumer spending — until it didn’t. Surging stocks help fewer Americans, but a selloff also doesn’t pose as much of a risk to the financial system as the implosion of the housing and credit-fueled expansion a generation ago.

Years of surging home values means households are also sitting on elevated levels of home equity, but these gains have been trapped by high interest rates — home equity loans are expensive and a lack of affordability has frozen home sales. Stock wealth, on the other hand, is available at the click of a button, and perhaps feels more like “money in the bank.”

Adjusted for inflation, gross domestic product grew by 2.8% in 2024, with consumption accounting for two-thirds, or 1.9 percentage points, of that growth. The wealthy accounted for almost half of all spending, according to the Wall Street Journal, which cited analysis by Moody’s Analytics. It helps explain why companies ranging from airlines to theme park operators have been upscaling their products.

Such high-earner-dependent growth raises questions about how the economy will fare if the stock market struggled. How differently would a wealth shock coming from stocks play out versus the one that emanated from housing in the late 2000s? With the housing bust, millions of construction jobs were lost, middle-class homeowners saw their net worth evaporate, and consumption got crushed. Banks found themselves over-leveraged and in need of bailouts. It took years to repair the damage to household and bank balance sheets.

A stock market decline of 20% or more — perhaps tied to a shift in investor sentiment around artificial intelligence — would erode the spending power of wealthy Americans. That may be enough to cause a consumption recession since consumer-facing companies have long bemoaned weakness among lower- and middle-income households.

The slump would probably knock the labor market out of its “low hiring, low firing” equilibrium and lead to layoffs and rising unemployment, and potentially a recession. It would also mean interest rates could fall in a more meaningful way than they have.

The Magnificent 7 technology stocks collectively comprise a third of the value of the S&P 500 Index, but account for less than 1% of total US employment once Amazon.com Inc.’s warehouse workers and drivers are stripped out. These companies have also had multiple rounds of job cuts over the past few years and controlled headcount while they invest heavily in AI. The risk of huge layoffs there, even if their stock prices fell sharply, doesn’t seem overly elevated.

Lower borrowing costs, on the other hand, would benefit households and boost the fortunes of companies tied to middle-class consumption. A housing recovery with owners able to tap their home equity would have more broad-based benefits than the narrow stock-market-led consumption boom we’ve been experiencing. Reduced financing costs would revive construction activity, and demand for workers in the building and manufacturing sectors. Eventually stocks and high-end consumption would stabilize.

This isn’t to say Americans without stock portfolios should be rooting for a recession — recessions hurt everyone — but there’s every likelihood that this would be a shallow recession. And the expansion on the other side of it would be beneficial to more Americans than the current economy that has been difficult for so many.

Credit: Bloomberg