Despite tariffs, political turmoil, and a weakening jobs outlook, the stock market’s continued growth is powering consumer spending and helping keep the economy from slipping into the recession many had expected by now.
Strong economic indicators
Recent economic data revealed a surprisingly strong performance. Consumer spending and incomes both outperformed expectations in August, with businesses and households still making big-ticket purchases while inflation has been relatively soft. Even the housing market showed renewed strength, with new home sales climbing to their highest level in three years.
Revised figures released Thursday showed that gross domestic product grew at a 3.8% annualised rate in the second quarter, half a percentage point higher than previously thought. Additionally, the Atlanta Fed raised its GDP tracking estimate for the third quarter to 3.9%, up 0.6 percentage points from its projection a week ago.
Commerce Department numbers released Friday reported a 0.6% rise in consumer spending for August, stronger than expected. Spending adjusted for inflation increased 0.4%, indicating consumers are coping with rising prices.
From stimulus to the wealth effect
In the past, such trends were largely fuelled by trillions in stimulus from both congressional spending and low interest rates and liquidity injections from the Federal Reserve.
Today, however, the story is changing towards the wealth effect coming from Wall Street as rising stock markets keep hitting new highs despite high valuations.
Mark Zandi, chief economist at Moody’s Analytics, said Friday on CNBC that he believes the stock market rebound is driving the wealth effect, with most spending coming from high-income, high-net-worth households whose rising stock portfolios make them feel better off and more willing to spend.
The stock market has steadily climbed this year, boosted not only by huge AI spending, no doubt, but also by gains in major industrial companies and communications giants. The Dow Jones Industrial Average has risen over 9%, while the tech-heavy Nasdaq Composite has climbed 23%.
Consumers tend to be happier when stocks are rising and unemployment is low, as is the case now. However, according to the University of Michigan, overall sentiment this year has steadily declined, dropping 23% since January when President Donald Trump took office.
A double-edged sword
Although the stock market has been setting new records this month, economist Mark Zandi warns that such strength could be resting on shaky ground.
“The economy’s very vulnerable if the stock market does turn south, for whatever reason,” he said. “People start seeing red on their screens and not green on their screens and the savings rate goes up not down. In the current context of no job growth, that’s recession.”
Valuations remain a concern
The main concern over the stock market is valuations. The S&P 500 is trading at 22.5 times expected earnings over the next year, significantly higher than its five- (19.9) and 10-year (18.6) trends, according to FactSet.
Even so, recent economic data show little sign of recession pressure.
Inflation is still above the Fed’s 2% target, with the core rate at 2.9%. However, monthly increases are consistent with previous trends and Wall Street expectations, keeping the Fed on track for a likely rate cut in October and potentially another in December.
“The economy has continued to surprise to the upside and despite the negativity captured in surveys and expressed by commentators, actions speak louder than words and consumers continue to spend, which is why corporate profits continue to exceed expectations,” said Chris Zaccarelli, chief investment officer for Northlight Asset Management.
More good news, more danger
There was more positive economic news this week as well.
Durable goods orders also unexpectedly increased, while new home sales jumped 20%. These gains came as a recent increase in jobless claims proved to be temporary, with layoffs remaining low, though payroll growth has also been flat at best.
“Often, when people feel pessimistic about the near-future economy, they begin reigning in spending, but that hasn’t been the case thus far,” said Elizabeth Renter, senior economist at consumer site NerdWallet. “In fact, the strength of the consumer is credited with keeping the economy strong for the past handful of years, despite high inflation, high [interest] rates and great uncertainty.”
However, Renter also pointed out that the economy is on a knife’s edge, with many consumers missing out on the stock market gains, and overall sentiment at recession-like levels. She explained that wealth provides some insulation from perceived economic volatility, and investors have generally been doing well.
“Consumers are attuned to the current economic risks — inflation and labour market weakness. This could be due to first-hand experiences — food prices rose significantly last month — or because they’re on edge from headlines tracking key economic data. In any case, people aren’t feeling great about the economy, their place within it or where it’s all headed.”
Risks and market speculation
Confidence that the market rally will continue has driven share prices higher in New York and London, even though the reasons for the optimism are shaky. In the UK, growth remains sluggish and inflation is running at almost double the Bank of England’s 2% target. Ongoing speculation about tax increases is also weighing on consumer and business confidence.
Wall Street’s record-breaking rally reflects a bet that artificial intelligence will boost economic growth. While that could happen, it will be years before the impact is felt. The same was said about the IT boom that drove share prices to dizzying heights in the late 1990s.
No two market crashes are the same. The current situation differs from 2008, when the crash was caused by banks’ overexposure to the US housing market, and turbocharged by the widespread use of new financial instruments that were meant to reduce risk but worsened it. If there are any parallels, they lie with the recession-driven stock market setbacks of the 1970s and early 1980s, when downturns were deliberately engineered to curb high inflation.
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