Rising oil prices and a sweeping US tax cut are raising a red flag for the bond market

Fears over the health of the global economy have tended so far to focus on factors such as rising US interest rates, a US-China trade war, a China economic slowdown or even the fallout from a no-deal Brexit.

But could a stock market sell-off trigger an economic slowdown or even a recession?

On the face of it, it seems unlikely. The S&P 500 is still up 275 per cent since its March 2009 post-crisis low. Most investors are sitting on healthy profits. Despite this autumn’s sell-off, it is still only 15 per cent down from its September high.

However, that fall means more than $3.7tn has been wiped off the value of the market in just three months. What is the effect of that on consumption?

Much depends on the period over which investors mentally measure their gains. There is a difference between paper profits that an investor is ‘gambling with’ and profits counted as part of their total wealth. With the S&P now down 6.5 per cent for the calendar year, investors could start to feel poorer as they enter 2019.

Research abounds on the actual size of the impact on the economy. A speech back in 2001 by then-Fed chairman Alan Greenspan put the effects at 3-to-5 cents of spending for every marginal dollar of wealth. Fed research that same year by Karen Dynan and Dean Maki put it at 5-to-15 cents, although added it was most likely at the lower end of the range.

“The direct wealth effect of a highly significant fall in the market will clearly slow the economy,” said Sushil Wadhwani, founder of hedge fund Wadhwani Asset Management and a former member of the Bank of England’s Monetary Policy Committee. A 5 cents assumption would mechanically knock 0.75 per cent off GDP growth, although because the market was near its peak only briefly, that may be on the high side, Mr Wadhwani said. That is still only a slowdown rather than a recession.

But other factors could exacerbate the impact. Some hedge funds feel market liquidity is broad but thin, and may quickly evaporate in a bear market. Stocks pushed higher by relentless buying from passive funds could find less fundamental support than they otherwise would as flows reverse. Markets off 15 per cent could quickly gap much lower.

Meanwhile, the effects of ending the huge decade-long experiment of quantitative easing are unknown. QE is widely seen as inflating asset prices and blamed by some for misallocation of capital in the economy. With global debt higher than its financial crisis peak, few underlying economic problems have been solved in the meantime.

The market crash of 1929 was, to an extent, a key factor in precipitating the Great Depression, exposing weaknesses in the economy. We are not close to that, but we could soon find out how much the market affects the economy.


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