Powell Says Stocks Play A Role In Economy’s Performance – Here’s What A Crash Would Mean

Jerome Powell said a lot of shit today and I guess we’ll have to wait until the close to draw any definitive conclusions about the extent to which he “successfully” navigated his first testimony on Capitol Hill without sending shockwaves through markets with an errant comment, but it seems like he did ok.

Yes, yields are up and sure, that’s predicated on his generally upbeat take on the economy (and remember, in this perverse world, good news is bad news to the extent it tips a more aggressive Fed), but the bottom didn’t entirely fall out for stocks at any point as he suffered through a tedious and largely asinine Q&A with lawmakers.

Anyway, Powell made a couple of comments on stocks that are worth noting. There was the obligatory “we don’t manage the stock market” line. He was “honest” enough to state the obvious, which is that stocks are of course part of the decision calculus. This is the reflexive relationship that has been deeply ingrained in markets over the past several years. It’s the “removal of the fourth wall” to quote Deutsche’s Kocic. The market effectively co-authors the policy script and is thus no longer simply an observer of a self-contained policy narrative. There’s a two-way communication loop and breaking that loop (i.e. the withdrawal of transparency) is the biggest risk for the Fed on the path to re-emancipating markets.

Powell also said this:

I think the general thing is the stock market is not the economy, but it is a factor.

It’s an important place for businesses to raise capital, it’s an important place for investors to invest.

Why yes, the stock market is “an important place for investors to invest.”

Jokes aside – because these soundbites always “sound” stupider when typed out than they do when you actually hear the person make them – it’s worth recalling that equities influence the economy in part through their effect on financial conditions.

Goldman has spent all kinds of time quantifying that of late and it came up again over the weekend when the bank “stress tested” the economy for a 2-standard deviation yield shock that would see 10s at 4.5% by year-end.

In the interest of providing a little bit of color on this for anyone who might have missed it (and for fuck’s sake, let’s just be honest with ourselves: even if you read it at the time, you’ve forgotten it), we’re reprinting a post from January that contains Goldman’s attempt to explain how a 20% drop in stock prices would feed through to the real economy. Enjoy (again)…

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From “What Would Another Black Monday On Wall Street Mean For The Economy? Goldman Answers” published on January 25 (so, incidentally, the day before the market peaked)….

The equity rally does benefit the economy even if the fabled “wealth effect” doesn’t operate with anywhere near the efficiency policymakers seemed to assume it does when they embarked on the greatest (or “worst” depending on your penchant for doomsday prophesying) monetary policy experiment the world has ever seen following the crisis.

On Wednesday, Goldman set out to quantify the effect of the rally on GDP growth in a note optimistically entitled “Wall Street And Main Street Intersect”.

This starts with the rally’s contribution to the continued loosening of financial conditions which, on Goldman’s measure, are the easiest since April 2000.

“We have argued that the most important reason for the acceleration in growth last year and for growth optimism in 2018 is the sharp positive swing in the impulse from financial conditions,” the bank writes, adding that “the run-up in the equity component of the FCI has accounted for roughly half of the 137bp index easing in 2017 and 80% of the of 32bp easing year-to-date.”

Ok, so as Goldman goes on to remind you, there’s some reverse causation going on when you start talking about equity prices and GDP growth. That is, higher stock prices are both a cause and an effect of better growth outcomes, so you have to control for that, and without getting into the details of the model, suffice to say Goldman tries.

Ultimately, they conclude that “equity prices are currently contributing nearly +0.6pp to real GDP growth, up from -0.25pp in early 2016, thus the stock market currently accounts for nearly two-thirds of the total +1pp growth impulse from financial conditions.”

That raises this question: ok, what would happen to that growth impulse were stocks to crash? Here’s Goldman’s attempt at an answer:

We first consider a sharp correction, where stock prices fall 20% in Q1 and stay flat afterwards, reminiscent of the 20% Black Monday crash in 1987. In this scenario, we estimate that the growth impulse from equity prices turns from a +0.6pp boost currently to a -0.5pp drag by early 2019 on a 4QMA basis, as shown in Exhibit 4. All other things equal, this bear market would still result in positive GDP growth in 2018 of 1.9% on a Q4/Q4 basis–significantly below our 2.6% baseline forecast–but have only a minor negative effect on growth in 2019.

One key bit there is “all other things equal”. It’s entirely fair to suggest that if we got another “Black Monday”, all other things would not in fact remain “equal”.

But taken at face value, what the above suggests is that if equities were indeed to correct by 20%, Trump’s growth “miracle” would look considerably less “miraculous”. Goldman also doesn’t attempt to posit what might cause such a correction, a key consideration for determining whether “other things” would indeed remain “equal”.