How significant is the wealth effect in a bull market?

Despite what you might read or hear, the stock market is not the economy.

But that does not mean you should ignore the effect of the stock market on household income and spending, the labor market, overall financial conditions and economic growth.

A 2021 paper in the American Economic Review found that an increase in local stock wealth driven by aggregate stock prices increases local employment and payrolls in nontradable industries. The result is that for every dollar of increased stock market wealth, consumer spending increases by 32 cents.

Given that the upper quintile of income earners is responsible for roughly half of all spending, this strongly implies an additional tailwind behind overall American household spending.

Using a back-of-the-envelope calculation, we estimate that the sharp rebound in equities last year contributed to an increase of roughly $900 billion in households' stock wealth, or $288 billion in consumer spending.

If we consider the spending multiplier effect, the total spending increase would be much higher, at $1.3 trillion. Based on those two numbers, the increase in total spending would account for between 1.1% and 4.8% of nominal gross domestic product, which grew by 6.3% in 2023.

Given the nearly 9% increase in the S&P 500 through March 19 following the 24% increase last year, this is a nontrivial development with respect to the direction of overall economic activity and household income, spending and savings.

Economic resilience and financial optimism

While monetary policy remains sufficiently restrictive, an eventual easing of financial conditions in the second half of the year is on the horizon and is an essential factor in the recent improvement in financial conditions.

The RSM US Financial Conditions Index improved to 0.13 standard deviations above neutral as of February, which implies that financial markets are neither a drag nor a tailwind to overall growth and is an indication of a strong economy.

But gains in equity markets in general and the valuations of a select number of technology stocks in particular were a tailwind behind spending last year and will most likely be again in the first quarter. These gains are occurring following, and despite, two years of a dramatically tight monetary policy. 

Our composite financial conditions index includes three factors: the equity market, in which the balance of risk and reward is one standard deviation above what would normally be expected; the money market, which has been neutral since last April; and the bond market, which remains one standard deviation below normally expected levels of risk and reward.

The Federal Reserve’s 5.25 percentage-point hike in interest rates since March 2022 has dampened overall demand and inflation, while the recent improvement in financial conditions is laying the groundwork for economic growth.

The tight financial conditions that characterized the past two years have eased, and we anticipate price moderation in two measures of inflation—the personal consumption expenditures index and the consumer price index—as we move toward the Federal Reserve’s 2% target.

We anticipate three 25 basis-point rate hikes this year, starting in June. Those cuts will also tend to improve overall financial conditions and support solid spending by upper-income households.

The reward for high-income households

The American Economic Review paper, which examined county-level data, indicates that increased stock wealth leads to increased local spending on nontradable goods, leading to increased employment. 

This was particularly the case in counties with higher levels of stock market wealth.

Nontradable industries typically include governmental services, education, health care, the construction sector and retail.

In contrast, tradable industries include manufacturing, agricultural production and resource extraction (that is, goods that can be shipped). In industries that mostly produce tradable goods, the American Economic Review paper found no increase in employment due to equity advances.

Interestingly, the authors’ analysis of data shows that no single state drove the results and that differences within states were persistent over time.

Fittingly, the authors wrote that the main threat to the paper’s causal interpretation of their findings is that high-wealth areas are responding differently to other aggregate variables that co-move with the stock market.

As the findings of the paper suggest, higher-income households with equity market exposure would have benefited from the unrelenting increases in stock market prices. With interest rates at zero for much of the decade before the pandemic, the stock market was the only game in town, and higher-income households reaped the benefits.

The wealth effect of the equity market was then compounded by the rapid increase in housing prices brought on by the unique circumstances of the pandemic era.

We can see the disparity in market returns, not only in the tech stocks of the S&P 500 compared to the overall index, but also in the Dow Jones index for home construction compared to the Dow Jones Industrial Average. Homebuilding is a nontradable industry and evidently was a good place to invest last year.