Assessing Yellen's Warning That Markets Pose a Threat to Economy

Former Yellen Adviser Says Recession a ‘Live Possibility’
  • Inside the wealth effect and what happens when IPOs dry up
  • Bear markets usually come about nine months before recessions

Federal Reserve Chair Janet Yellen told Congress Wednesday that weakening stock prices pose a risk to the economy, indicating to investors a more gradual approach to rates. But how should everyone else feel with stocks down 10 percent 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 LLC in July 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. Bloomberg data shows that since 1929, bear markets have come on average nine months before the start of recessions.

Yellen’s testimony before the House Financial Services Committee addressed the possibility 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 labor market,” particularly if they persisted.

Shares sank again Thursday, with futures on the S&P 500 down 1.8 percent at 8:21 a.m. in New York.

“The stock market, unlike what many other people believe, is not like the weather forecast -- it’s like the cigarette butt in the forest,” Roger Farmer, distinguished professor of economics at the University of California, Los Angeles, said in an interview with Joe Weisenthal on Bloomberg TV. “If the stock market drops by 10 percent you could expect the unemployment rate to be 3 percentage points higher than it would’ve been in the absence of the drop.”

Here are three ways that declines in stock prices could influence economic growth.

Wealth

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Almost $3 trillion in share 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 take over in accelerating expansion.

Americans have a lot of money in the market. As of September, households had $17.1 trillion invested in stocks, representing 35.5 percent of their financial assets, Federal Reserve data compiled by Ned Davis Research Inc. show. While the proportion was down from a peak of 38.8 percent in 2014, it compares with an average of 27.4 percent since 1951 and trails only 1965, 1968, 2007, and the years of Internet bubble.

“If you get significant swings in stock averages, it will affect wealth and spending decisions,” said Alan Gayle, senior strategist for Atlanta-based Ridgeworth Investments, which has about $42.5 billion. “The stock market is a daily barometer that most consumers will monitor on an ongoing basis. 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 and share sales, more than $1.7 trillion of stock has been sold, including $228.9 billion last year.

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 Holdings Inc. In January 2015, 19 companies listed on American exchanges. The busiest month in the past eight years was July 2014, when 54 companies started trading.

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. Brokerages, insurance companies and lenders make up the second-biggest proportion of the S&P 500 and are also important sources of employment in the broader economy.

About 8.2 million people, or 5.7 percent of the U.S. workforce, held jobs in the broader financial industry, including insurance and real estate. Hiring has increased in this sector for the past 29 consecutive months, though remains 2.2 percent below its November 2006 peak.

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“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 John Canally, chief economic strategist at LPL Financial Corp. in Boston. “It would put a chill on geographical areas like London and New York that are important financial centers.”

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