How the ‘wealth effect’ shapes US markets now

Market performance as Fed policy?

As equity markets now play an outsized role in the US economy, Aul and his team have found that a sustained 10 per cent market correction would result in a 14 per cent decline in US GDP. That connection could make the so-called ‘Fed put,’ which posits that the US Federal Reserve will intervene in the case of severe market downturns, an essential part of US economic policy.

While US policymakers may be incentivized to support and backstop market performance, US inflation still remains above the Fed’s stated target range of two to three per cent. That higher inflation and the more terse and hawkish tone set by new Fed Chair Kevin Warsh, has some analysts predicting that US interest rates will remain ‘higher for longer.’ Aul notes, however, that we shouldn’t view contemporary rates as ‘higher,’ but rather look at the regime of near-zero interest rates that came before them as abnormal. Where US interest rates sit today is closer to the historic bounds of normalcy, giving the Fed capacity to support markets or the economy with rate cuts if needed.

Inequality and the ‘K-shaped economy’

One of the features of the wealth effect in the United States is that it has exacerbated wealth inequality. Those who own assets, or earn enough to invest a meaningful part of their incomes have enjoyed market outperformance and expansion of their wealth, which has enabled them to consume and invest more. Those who don’t own assets and who don’t earn enough to invest, don’t participate, which exacerbates the so-called ‘K-shaped economy’ where a small cohort at the top do better, drive growth, and drive spending while a significant body of Americans find themselves worse off.

Should the upper leg of the K start to weaken and see their spending or asset growth collapse, there could be a risk for the wider US economy and equity market. Aul is measuring that risk by looking at the labour market, with the view that if upper income job losses become more acute then we may see the beginnings of a downturn in the wider US economy.

There is also a degree of political and policy risk that could be introduced by growing inequality, especially in an election year. Aul notes that US politics introduces layers of complexity that advisors and asset managers are best served by avoiding, but that most of the populist policies built around inequality now are more directed at billionaires and the top 0.1 per cent. Possible risks to the wealth effect, he says, would only take hold if policies were enacted targeting the wider mass-affluent base of asset owners.