Wall Street and the economists

Economists generally take great interest in the behaviour of financial markets. Asset prices depend on the flow of payments, interest rates and the risk premium demanded by investors. The dynamics of these three factors is highly cyclical. Asset prices – whether equities, bonds or real estate– tend to reflect investors’ expectations of growth and interest rates.

From an economic perspective, the market cycle can be broken down into three phases. The first phase is marked by a sense of relief and hope. Towards the end of a recession, the equity market begins to pick up as major interest rate cuts fuel expectations of an eventual rebound in activity. The next phase is anchored in confidence: the upturn in equity prices is driven more by earnings prospects rather than by the monetary environment.

We are currently in the third phase. Thanks to the combination of a very buoyant cyclical environment and below-target inflation, central banks have been able to maintain accommodating monetary policies that support growth. As a result, there are high expectations for cash flows and dividends, while key rates can be kept low. Investors are confident and are of the view there is little risk of a cyclical downturn. As a consequence, the appetite for risk is high. This third phase is a time of vigilance. Of course, one should welcome the equity markets’ buoyant momentum, which clearly illustrates the success of an expansionary monetary policy in previous years. The market environment also supports growth, by providing companies with advantageous financing conditions and creating a wealth effect for households. Yet this bullish momentum also raises several questions. In the United States, rising household wealth and confidence are closely correlated: buoyant equity and real estate markets bolster household confidence and spending, but the savings rate also tends to decline. A sharp drop in the equity market could hurt consumption. Higher asset valuations also makes them extremely sensitive to changes in economic fundamentals, such as a surge in inflation, higher interest rates, or a sudden slowdown in growth.

To conclude, now more than ever, Wall Street’s excellent performance has caught the attention of economists. Although an undeniable support factor for growth, the bull market also raises the question of its sensitivity to any changes in economic and monetary prospects.