It’s getting harder to separate the stock market from the economy

This is because rising asset prices motivate consumers to spend more freely than before, and consumption represents about 70% of GDP. In fact, the so-called wealth effect has only become stronger in the past fifteen years.

Today, every 1% increase in stock wealth translates into a 0.05% increase in consumer spending, according to a note last week from US economist Bernard Yaros, chief economist at Oxford Economics.

In other words, a $1 increase in stock wealth leads to a marginal propensity to consume of $0.05, up from less than $0.02 in 2010. On the other hand, every $1 increase in housing wealth raises consumption by about $0.04, up from $0.03.

“As households see their wealth rising, they become more optimistic about their personal financial situation and more likely to loosen their portfolio constraints,” Yaros wrote. “Increases in wealth will also drive spending by allowing homeowners to extract more equity from their homes or monetize rising equity to finance their current consumption.”

He argues that the wealth effect sends the marginal propensity to consume higher in the coming years because retirees will constitute a larger proportion of the population.

Yaros explained that given that they already have greater net worth than younger generations, retirees will rely more on their wealth to support consumption after they stop working and earning income.

Furthermore, the ubiquity of digital media means that consumer sentiment reacts faster to market news, reinforcing these wealth effects.

This stronger wealth effect can help explain why consumer spending remains resilient. Although President Donald Trump’s trade war has kept inflation flat and made companies more concerned about adding workers in an uncertain landscape, artificial intelligence is still pushing the stock market to new record high after record high.

At the same time, the stock market has become more dependent on AI-related stocks, such as chip leader Nvidia, as well as so-called hyperscalers like Microsoft and Google.

Based on his calculations of the wealth-to-spending ratio, Yaros estimated that stock market gains in the past 12 months from the technology sector alone would boost annual consumption by about $250 billion, representing more than 20% of the cumulative increase in spending.

“Although the stock market is not the economy, the latter risks a greater hit than the ups and downs of the former,” he wrote.

Analysts at JP Morgan also looked at the relationship between the AI ​​boom and consumers in a note last month. They estimate that US households gained more than $5 trillion in wealth last year from 30 AI-related stocks, raising their annual spending by about $180 billion.

This represents just 0.9% of total consumption, but JPMorgan noted that it could rise if artificial intelligence stimulates gains in a wide range of stocks or in other assets such as real estate.

Stocks aren’t limited to wealthy Americans, either. A survey released last month from BlackRock and the Commonwealth found that more than 54% of Americans who earn between $30,000 and $79,999 annually are retail capital markets investors. More than half of this group started investing in the past five years.

To be sure, the wealthiest still spend the most dollars, and the emerging K-shaped economy has amplified their influence. Research by Moody’s found that the top 10% of earners accounted for half of spending in the second quarter, a record high.

Michael Brown, chief research strategist at Pepperstone, attributed this to the wealth effect from gains in stocks and real estate as well as from income inequality.

“Tying all of this together produces two things — an economy that increasingly relies on discretionary spending among higher earners, and higher earners whose discretionary spending depends on risk assets remaining buoyant,” he said in a note Tuesday.

This dynamic means that Fed central bankers who control monetary policy and lawmakers in congress who control fiscal policy have a greater incentive to support the stock market, Brown added.

This is because the wealth effect can work in the opposite direction, meaning that falling asset prices will slow spending and the economy.

“What we have then is an economy that is increasingly closely linked to stock market fortunes, and a stock market that is increasingly linked to overall consumer spending, which coupled together results in a stronger ‘sell’ structure to support risky assets, as fiscal stimulus continues and monetary backdrops become more flexible,” he said.