RateWatch #221 - The Wealth Effect

What's Happening?

We believe that borrowers must note that we are still in a bull cycle for bonds (lower rates). A prime opportunity for refinancing will occur very early in 2001. The next Fed move will likely be a loosening of rates.

This was a week in which the movement of the equities markets seemed as predictable as the path of a pitch from St. Louis Cardinals pitcher Rich Ankiel.

The Wealth Effect

Since a lot has been said in the past week about equities this might be an appropriate time to revisit an old topic - the wealth effect. More people than ever own stocks and mutual funds. The increase in the value of their portfolios has created a significant amount of wealth.

The "Wealth Effect" refers to the propensity of folks to spend more if they have more assets. This seems intuitive enough. If someone has $200,000 in their brokerage account they will certainly be able to afford a down payment on a house - even here in San Francisco. They are also more likely to buy stuff... maybe.

The presumption is that some or most of the expansion in GDP and consumer spending has resulted from this wealth. The concerns are twofold:
1) with this wealth outside control of the Federal Reserve does the Fed really have the control of the economy that it is supposed to. Worse yet, does it have any real control?
2) what is going to happen to the economy if the market tanks?

The Premise

The premise is that when the value of equities rises the wealth thus created makes folks feel more comfortable about spending. This sounds logical enough. There is no accurate accounting of the correlation between equity growth and spending but it may be as high as 4%. That is, for every $1 billion in increase in the value of equities, Americans will spend an additional $40 million a year. From 1994 to present the stock market has added about $14 trillion to the wealth of Americans. That translates into $560 billion in additional spending a year. If there is a wealth effect then it is certainly helping keep the economy growing.

The Bear

We have had a 10-year long bull market for equities. It was fueled by an increase in corporate profits coupled with the assumption that this would continue.

Common sense dictates that at some time this market will suffer a severe correction. The cause may be exogenous to the economy. It may be oil. It may be a serious confrontation between North & South Korea. It may be a massive computer virus. It may be a comet strike.

There are some recent market corrections to fall back on for reference. The one that occurred in the later part of 1998 was short-lived. The Dow recovered nicely and there was no noticeable effect of spending.

The last stock market "crash" that seemed to have any effect on the economy was the October 19, 1987 "event". The market dropped 508 points, a net loss of 22.6%. This was the worst single day % lost in history. $800 billion in people's wealth was gone.

The equities markets were exposed to considerable systemic risks at that time. "Specialists" who's job it is to maintain liquidity had to buy shares themselves and had to be able to clear those transactions in 5 days.

All players needed additional credit to continue. Banks were nervous and potentially reluctant to lend. The drop in asset prices cast doubt on the creditworthiness of all parties: investors, specialists, brokerages, and clearinghouses. The reluctance of banks and other creditors to issue further loans would itself increase the risk of default.

The Federal Reserve issued an affirmation that it would be a source of liquidity to support the whole darn thing. The market corrected nicely. The Fed followed with a 1% drop in the Fed funds rate. This was followed by a tightening in 1988-1989 and a subsequent recession in 1990-1990 which might have been the only after-effect. In 1991 the economy started recovering and hasn't stopped.

So What?

The question remaining is this: what would it take in the way of an equity hit to leave some permanent damage as a result of a crash and a "reverse wealth effect?" The answer is likely something more that a 30% sell off lasting for at least a year.

The Lack of Wealth Effect

Spending, in late 20th century America is not fueled merely by wealth. It is also fueled by easy credit. People who are not wealthy still have access to credit and can spend. About 6 years ago I received a loan application from a person who has credit card balances equal to 2 1/2 years worth of his income. This gentleman was fueling the economy on borrowed money.

I think that a conclusion is this: the wealth effect certainly gives people the ability to spend. But even a sharp reduction in wealth from an equities contraction can be met with easy credit which will keep anything other than a mild recession from occurring. What would be needed at such a time would be liquidity. (Read RateWatch #333 on liquidity.)

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