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How Far Do Stock Markets Influence the Real Economy

Posted: February 8, 2020 at 7:51 am   /   by   /   comments (0)

The stock market movement can have a profound economic impact on the economy and individual consumers. 

A collapse in stock prices can lead to large-scale economic shocks. The most famous event was the collapse of the stock market in 1929, which was the critical factor that accelerated the Great Depression in the 1930s. 

However, daily movements in the stock market may also have less impact on the economy than we might have imagined, because the stock market is not a real economy. 

Share prices can change for many reasons. For example, correcting an overvaluation or even a significant drop in stock prices does not necessarily lead to a slowdown in growth.

The fact is that a rapid drop in stock prices does not necessarily mean that the economy is working badly. 

However, a reliable near future report review will give you a good look at the market and its impact.

FTSE_100_index

Source: Thrapper, Wikipedia. CC-SA-BY 3.0

For example, the 1987 stock market crash did not cause any economic damage to the actual economy. (although it had an impact on monetary policy). 

The UK lowered interest rates due to the fear that the stock market crash would lead to recession. Low-interest rates lead to an economic boom with rapid economic growth instead. 

The stock market crash in 1987 (when stocks fell by 25%) did not reflect severe economic problems, and the economy continued to grow at a decent rate worldwide.

Also, the fall in share prices from 2000 to 2004 was a period of economic growth in the UK – see great moderation.

However, the fall in stock prices in 2008/09 reflected real economic problems and may have contributed to the economic downturn.

A sharp fall in share prices could be a news headline. How will this affect the average consumer? And how does it affect the economy?

Economic Effects of The Stock Market

1. Wealth Effect

The first impact is that people who have stocks will see their wealth fall. If the decline is significant, it will affect their financial prospects. 

If they lose money on stocks, they will be more hesitant to spend any more money; this may contribute to the fall in consumer spending. 

However, this effect is not that important. 

Often, people who buy stocks are wealthy and willing to lose money. Their spending patterns are usually independent of the stock price, especially in the case of short-term losses. 

Besides, only about 10% of households own equities. For most consumers, a drop in equity prices will not directly affect them.

The effect of wealth is more visible in the property market. (e.g., falling property prices have an impact on more consumers).

2. Effect on Pensions

Anyone with a private pension or an investment trust fund will be affected by the stock market (at least indirectly). 

Therefore, if there is a severe decline in the price of shares, it reduces the value of pension funds. That means that in the future, pension payments will be lower. 

If share prices fall way too much, pension funds may have difficulty fulfilling their promises. Therefore, long-term movement in the share price is essential. 

If the share price drops for an extended period, it will undoubtedly affect the pension funds and future payments. That may lead to lower pension income for households, and they may feel the need for additional savings and consider other investment options.

3. Confidence

Often share price movements are a reflection of what is happening in an economy. For example, fear of economic and global recession can lead to a fall in stock prices affecting consumer confidence. 

Bad headlines about a decline in stock prices are another factor that discourages people from investing money. For example, the fall of the stock market in 2008/09 reflected a decrease in consumer confidence. 

In itself, it may not have a significant impact, but when combined with falling property prices, share prices may become a factor that discourages people from spending. 

However, there are cases when the stock market may not be the same as the rest of the economy. In a deep recession, equity prices may rise as investors look forward to a recovery in the future.

4. Investments

A fall in share prices may prevent a firm from raising funds on the stock market. Firms that are expanding and want to borrow money often do so by issuing more shares. That provides an inexpensive way to borrow more money. However, as share prices fall, it becomes much harder.

5. Bond Market

The fall of the stock market makes other investments more attractive. People can exit stocks and move into government bonds or gold. 

These investments give better returns in times of uncertainty. Although, the stock market may sometimes fall due to concerns in government bond markets (e.g., Euro fiscal crisis).

How Does That Affect Ordinary People?

Most people who do not own shares will not be significantly affected by short-term movements in the stock market. However, ordinary employees will not be completely unaffected by the stock market.

1. Pension Funds 

Many private pension funds will invest in the stock market. A significant and prolonged decline in the stock market may lead to a fall in the value of their pension fund. That will also decrease pension payments upon retirement. 

Similarly, if the stock market functions well, the value of pension funds may increase. Even if people do not own shares, people with private pensions will likely have some connection to the stock market.

stock-ownership

However, most of the shares belong to 10% of the wealthiest income owners. According to this article on middle-class welfare, the most deficient 90% of income holders own only 7% of all shares. Thus, the fall in share prices primarily affects the wealthiest 10% of households.

2. Business Investment. 

The stock market can be a source of business investment, for example, firms that offer new shares to finance their investments. That may lead to more jobs and growth. 

The stock market may be a source of private funding when bank financing is limited. However, the stock market is not usually the first source of financing. 

Most investments are generally financed by bank loans rather than stock options. The stock market plays a limited role in determining investments and jobs.

3. Short-termism. 

It can be argued that employees and consumers may be negatively affected by the short-termism promoted by the stock market. 

Shareholders usually want significant dividends. Therefore, companies that are listed on the stock market may feel pressure to increase their short-term profits. 

That can lead to cost-cutting, which will harm employees, or the firm may be more tempted to engage in a conspiracy that pushes up consumer prices. 

It is argued that UK firms are more likely to act in the short term as the stock market plays a more significant role in financing companies. 

In Germany, companies are more likely to be financed by long-term bank loans. Banks are usually more interested in the long-term success of firms and are more willing to encourage more investment rather than maximizing profits in the short term.

Summing Up

After all, the stock market and the economy are not entirely the same thing. However, they strongly influence each other. We will continue to monitor these relationships as we follow the investment landscape closely.

However, most of the shares belong to 10% of the wealthiest income owners. According to this article on middle-class welfare, the most deficient 90% of income holders own only 7% of all shares. Thus, the fall in share prices primarily affects the wealthiest 10% of households.

2. Business Investment. 

The stock market can be a source of business investment, for example, firms that offer new shares to finance their investments. That may lead to more jobs and growth. 

The stock market may be a source of private funding when bank financing is limited. However, the stock market is not usually the first source of financing. 

Most investments are generally financed by bank loans rather than stock options. The stock market plays a limited role in determining investments and jobs.

3. Short-termism. 

It can be argued that employees and consumers may be negatively affected by the short-termism promoted by the stock market. 

Shareholders usually want significant dividends. Therefore, companies that are listed on the stock market may feel pressure to increase their short-term profits. 

That can lead to cost-cutting, which will harm employees, or the firm may be more tempted to engage in a conspiracy that pushes up consumer prices. 

It is argued that UK firms are more likely to act in the short term as the stock market plays a more significant role in financing companies. 

In Germany, companies are more likely to be financed by long-term bank loans. Banks are usually more interested in the long-term success of firms and are more willing to encourage more investment rather than maximizing profits in the short term.

Summing Up

After all, the stock market and the economy are not entirely the same thing. However, they strongly influence each other. We will continue to monitor these relationships as we follow the investment landscape closely.


Author’s bio: Dmitrii B. is the founder of GRIN tech – full service agency

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