In addition to boosting the intangible “wealth effect” by raising consumer confidence and encouraging spending, rising stock prices have a benign effect on the broader economy by directly stimulating US economic growth and GDP. And vice versa: when stocks drop, tightening financial conditions, US GDP is impacted adversely.
That’s the observation made in a Friday note from Goldman economists, which tries to quantify the growth effect of the equity sell-off, and finds that “the stock market is likely to turn from a significant contributor to strong growth at the start of the year into a modest drag next year, barring a further rebound in equity prices.”
Picking up where another recent Goldman note left off, concluded that the Fed will have to hike rates more than the market expects in order to substantially tighten financial conditions and slow down the economy, bank economists Jan Hatzius and Dean Struyven write that “the 6% decline in the stock market since late September has been the most important driver of the recent tightening in financial conditions.” As a result, the bank now estimates “that the 0.5% boost to GDP growth from higher equity prices at the start of the year has already disappeared.”, according to zerohedge.com
Conversely, the 6% sell-off in the S&P 500 since the September all-time high has been the biggest factor in the tightening of financial conditions and has accounted for two thirds of the roughly 50bp FCI tightening over the last month (other factors include the rise in rates and the dollar which account for about half of the -1.5% swing in the FCI impulse from +0.75pp at the start of the year to -0.75pp in the first half of next year).
FCI- Facility Condition Index
Looking ahead, between the Fed’s own tightening posture and potential continuation of the equity selloff, Goldman expects a decline in the equity impulse to real GDP growth to about -0.25% in the first half of 2019. This assumes that the equity component of the Financial Conditions Index stays at current levels, which is “roughly consistent” with Goldman’s forecasts for a 2019 year-end level of 2,850 on the S&P 500 and $159 EPS by end-2018.
Source: Goldman Sachs Global Investment Research
First, the good news: should the recent market weakness fade, and stocks rally, Goldman assumes that the S&P 500 can rise about 4% per quarter to 3,350 by end-2019, roughly 15% above the September peak. In this case, the growth impulse from equities will rebound to +0.25pp in the second half of next year, and the continuation of the bull market “will likely keep GDP growth in 2019 well above potential at 2.4% on Q4/Q4 basis.”
Next, the not so good news: should the sell-off continue and stock prices fall an additional 10% in Q4 to around 2,500 and stay flat, some 15% below the September all-time high, Goldman estimates that the growth impulse from equity prices would turn from a neutral factor today to a -0.75pp drag by Q2 2019, as shown in the chart below. According to its calculations, Goldman concludes that such a decline would push GDP growth down to 1.6% in 2019 on a Q4/Q4 basis, below our estimate of potential and well below our 2.0 percent forecast.