A two-speed economy has been a fact of life in the UK for much of the past year, a booming consumer sector offsetting shrinking manufacturing.
Less obvious is the fact that the personal sector itself is moving in two directions at once. Household wealth has been increased by house price inflation but decreased by falling equities. So deep have been the falls in share prices in London and on Wall Street that there are fears the global recovery could be jeopardised. There is a fear that weak shares could affect growth, with depressed markets and weakening activity feeding off each other.
The fact that some commentators have gone so far as to compare George Bush’s pronouncements on the subject with those of Herbert Hoover 70 years ago shows how seriously the situation is being taken. But this overstates the case. The original Wall Street crash was precipitated by a global economy still in dislocation after the Great War and the ill-conceived Peace of Versailles. The policy responses to the crisis were, moreover, totally inappropriate. Today, in the US and UK, the economic fundamentals are in good shape and, by lowering interest rates on both sides of the Atlantic, policymakers have staved off prolonged recession.
Yet the FTSE and the Dow are still ignoring these trends. Their continuing slide seems to justify the old saying that equity markets have accurately predicted seven of the last two recessions, implying not only that markets often get it wrong, but also that the wider impact of weaker share prices will be quite limited. Recently, Federal Reserve Bank chairman Alan Greenspan estimated that a $1 change in equity prices affected spending by between three and five cents. On this measure, the fall this year on Wall Street points to a modest 0.5% to 0.75% off GDP after a year.
Changes in the structure of the UK economy, however, suggest that such mechanistic links may not tell the whole story. During the 1980s, share ownership was so successfully encouraged that today 12m people are shareholders in their own name, 3m more than currently belong to trade unions. In addition, through indirect holdings via pension schemes and savings vehicles such as PEPs and ISAs, many more are dependent on the performance of equity markets. If people are getting poorer, spending must be affected.
Analysis at HSBC concluded that direct equity holdings accounted for 12% of household wealth, a doubling over the past 20 years. A further weakening in the value of these assets will damage consumer confidence and eventually slow spending growth. There is a further 30% of personal wealth tied up in pension funds, which are more long-term and much less liquid. Ultimately, these losses, if permanent, will have to be made good by bigger future contributions, but this additional pressure on spending is not immediate.
Although damaging, these consequences for the personal sector are more than outweighed by the estimated 42% of household wealth associated with housing. Despite the fact its share has fallen (from 57%) as financial assets have become relatively more important, the housing market remains the dominant influence on consumer confidence and spending. Home ownership (70% of households) is still more widespread than share ownership and the rise in house prices will add more to spending (2.5% in the next year) than the fall in share prices will reduce it (up to 1%).
The corporate sector will not be unscathed by a FTSE that stays below 4,000 or a Dow Jones that hovers around the 8,000 mark, since it could be a disincentive to invest. It is worth remembering, however, that falling share prices reflect a lack of investor, rather than business, confidence, and recent confidence surveys report sentiment recovering in line with the basics of the economy. A more serious issue is that falling equity prices imply a higher cost of capital for companies. This again could choke off investment.
It is impossible to regard the weakness in shares as positive for the economy, although conventional wisdom suggests the overall economic impact will be muted. How long the malaise will last depends partly on why it happened. If “irrational exuberance” hyped the market; if in terms of historic price/earnings ratios the market is still overvalued; if accountancy malpractices are keeping prices low by undermining confidence; and if the whole downturn is part of the adjustment to low inflation, there is no reason to expect an early bounce-back. However, if growth depends on the economic fundamentals, then the only way is up.
For the UK, the housing market is pivotal in keeping consumer confidence buoyant, particularly after June’s dreadful manufacturing numbers – so any rise in base rates to cool the housing market could have unwelcome consequences.
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