Falling Stocks Can Ding the Economy

A stock market drop is painful for investors, but the aftereffects can be a punch in the gut for the economy overall. A key risk to economic growth in 2019 is that a falling stock market could cause people to pull back on spending, which is ominous, considering that consumer spending has powered nearly three-fourths of the growth during the current economic expansion, according to the Bureau of Economic Analysis. “The correction in stock prices, if sustained, will do some damage to economic growth in 2019,” says Mark Zandi, chief economist of Moody’s Analytics.

Consumer spending has been turbocharged by the so-called wealth effect, an economic yardstick that measures how changes in household wealth affect how much people spend. Given the rise in stock holdings and home prices, the wealth effect has lifted consumer spending, adjusted for inflation, by more than $600 billion during this economic expansion, Moody’s calculates.

But the wealth effect can do more damage on the way down than it helps on the way up. Retirement savers are more sensitive to the threat that their savings may fall short than to the possibility that they are saving too much. Investors who are saving for retirement tend to have a certain savings goal each year, and if a drop in stock market values causes their retirement portfolio to fall below that level, they are more likely to save more and spend less.

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A rough rule of thumb is that when stock market values fall, consumers will replace 5% of the losses with extra saving. A 10% drop from the market’s September peak would cause a reduction in spending of roughly $150 billion, if stock prices were to remain 10% lower for one year. In that case, gross domestic product growth would be knocked down by roughly 0.7 percentage point, and Kiplinger’s forecast of 2.6% growth for 2019 would be revised downward to 2% or potentially even less.

It’s unclear what impact the recent stock market turmoil will ultimately have because there’s a lag between the change in asset values and the impact of the wealth effect. The peak impact generally occurs one year after the change in wealth. And although Standard & Poor’s 500-stock index fell about 10% from the high it reached last fall through early December, corrections tend to recover in a matter of months. Also, rising home prices offset market losses when it comes to gauging the impact of the wealth effect. A bear market would pack a bigger punch, but even then, an uptick in government spending in 2019 could cushion the blow to the economy.

Where It Would Hurt Most

Still, you can expect lower stock prices to lead to tightened purse strings and fatter bank accounts. Spending on nonnecessities is cut the most when consumers boost savings. Travel tends to suffer first, with cutbacks in spending on airfares and hotels. The categories that are least affected include consumer staples, such as drugs and groceries.

The parts of the country that are most affected by changes in stock market wealth are the Northeast and the Pacific Coast. Residents there hold an outsize share of financial market wealth, and more people in those regions than elsewhere in the U.S. are employed by the financial services industry, where bonuses tend to be a larger share of compensation.