The Stock Market Rout Can't Breach the U.S. Consumer Firewall
As the dot-com bubble burst, then-Federal Reserve Chairman Alan Greenspan said the last firewall between the U.S. economy and a recession is consumer confidence. Given the market's plunge this year, will it hold now?
So far, so good.
The risk facing the U.S. is that falling stock prices cause people to start worrying about their finances, and they spend less.
But with oil prices curtailing inflation and incomes rising, the outlook in many developed countries, including the U.S., seems to belie the gloomy narrative. So, is there really any reason to worry about falling asset prices?
Here's the S&P 500 - down almost 6 percent this year - versus the University of Michigan index of consumer confidence.
For the U.S., the case for concern may be more compelling than elsewhere, with household spending accounting for 70 percent of GDP and studies highlighting a link between equity prices and consumer confidence.
That's not only because of the direct fallout on those who own the assets. A 1999 Fed paper found a strong correlation between consumer sentiment and stock prices.
"Using individual observations from the Michigan [Consumer Sentiment] survey, I found that sentiment levels of households that owned stock and those that did not responded similarly to a change in overall equity prices. This suggests that households use changes in stock prices as a leading indicator of future income.''
The significance of stock price moves on output hinges on the degree of financial-market penetration in a given society. So, not only the direct holding of assets, but also coverage of market moves in the media and awareness among the public of how this affects savings, such as pensions or 401(k) plans.
The key is how long the fallout lasts. Once that happens, the hit to sentiment can become self-reinforcing, transmitting a financial market downturn to the wider economy. This is traditionally seen most acutely with housing-market crashes.
While the latest downturn is threatening confidence, real-income gains from cheaper energy should allow the U.S. consumer to mitigate at least some of the impact. That said, the Conference Board's measure of household sentiment dropped to a seven-month low in February.
Perhaps most worryingly, the Conference Board survey showed the percentage of U.S. consumers expecting lower income over the next six months hit its highest level since September 2014 - although it remains some way below the percentage expecting higher income.
It's worth noting that during the fallout from the bursting of the dot-com bubble, consumer sentiment dropped with the market, but once stocks had reached their nadir, the recovery in sentiment outpaced stock gains. Moreover, U.S. retail sales remain buoyant, rising for a third straight month in January.
"There is a reasonably strong relationship between sentiment and household net wealth, but that's largely driven by house prices," says Azad Zangana, senior economist at Schroders.
"Wealth effect channels are stronger in the U.S. than in Europe, but consumers so far appear to have done a reality check. At the moment economic indicators are looking healthy."
With average earnings also starting to show signs of picking up, the great firewall of U.S. consumer confidence may once again prove strong enough to repel the assault of market turmoil.