Stock drop could pose risk to U.S. economy — if it endures

So far at least, there’s little sign that the correction in the Dow Jones industrial average — it dropped 10 percent from its peak late last month — will squeeze the economy. After rallying by the time the market closed Friday, the Dow is still about 50 percent above where it was after its last correction in February 2016. Most economists see the current drop as an inevitable result of stocks’ rapid ascent since then. And few think most investors are about to curb their spending.

Market declines that do end up derailing an economy are typically triggered by financial imbalances — unsustainable debt, for example, which ignited the Great Recession in 2007. Americans haven’t taken on nearly as much debt as they did before the financial crisis. Banks have much more cash in reserve. Regulations have reduced the kind of high-risk mortgage lending that fed the 2008 financial crisis. Corporate profits are strong and growing.

“The economy looks quite resilient to this type of relatively modest shock,” said Gregory Daco, chief U.S. economist at Oxford Economics.

Referring to the stock market’s swoon, Daco said: “We might be seeing a more normal evolution of things. Ups and downs are not atypical.”

Still, if stocks should fall into “bear market” territory — defined as 20 percent below recent peaks — or plateau for months without any real gain, the economy would face greater risks.

Consumer confidence would likely suffer. Diminished household confidence tends, over time, to slow growth. Americans are collectively far more likely to spend more — especially for costly purchases like homes, cars and vacations — when their household wealth is stable or growing and they’re optimistic about their financial futures.

Confidence among consumers and businesses jumped after President Donald Trump’s election and reached a 17-year high in November. Stock prices rose, and so did consumer spending.

What economists call the “wealth effect” is the phenomenon that occurs when growing home values and stock prices make people feel richer and more secure. Households tend to spend down some of that wealth, thereby boosting the economy.

Conversely, when household wealth shrinks significantly, the reverse tends to occur: People, feeling less confident about their finances, usually spend less.

One trend that may shield the broader economy this time is that, according to many analysts, the wealth effect is smaller than it was before the recession. A key reason is that Americans have been a bit more frugal for the past decade, with many regarding their housing or stock market wealth as more ephemeral than they did in the past.

Since the recession, consumer spending has grown about one penny for each dollar of additional stock market and housing wealth — down from 3.5 cents before the downturn — said Michael Feroli, an economist at JPMorgan Chase. As a result, spending might not fall as much this time.

Even if the wealth effect is less pronounced, it still has an impact. The sharp rise in share values in the past year — before the past week’s correction — added about $8 trillion in household wealth. Even if just one penny of every dollar of that gain were spent, it would translate into $80 billion, or about one-quarter of the overall increase in consumer spending in 2017, Feroli said. A reversal of that trend could pinch the economy.