The Consumer and the Stock Market
As the “wealth effect” is driven less by house prices and more by investment markets, it may change our views on asset valuations and portfolio construction.
Today’s CIO Weekly Perspectives comes from guest contributor Shannon Saccocia.
The U.S. consumer is king.
Little has occurred over the past four decades to upset that assumption. In fact, the importance of the U.S. consumer as a driver of global economic growth seems only to be increasing in this post-pandemic world.
But the strength in consumer spending coming into 2023 seemed in jeopardy, according to many economists—and it wasn’t due only to higher prices, but also the deleterious impact of declining investment portfolio valuations on household wealth, and the fear of imminent downward pressure on home prices.
Housing Wealth Effect or Financial Wealth Effect?
This phenomenon is known as the wealth effect. It is a fundamental theory in behavioral finance, and it describes the likelihood for consumers to spend more as their assets increase (or vice versa )—absent any change in their income.
Considerable research has been undertaken to parse out the significance of home price appreciation and depreciation, and changes in capital market portfolio values, with the findings changing over time.
Karl Case and Robert Schiller, for example, tackled the notion of the wealth effect twice—once over the period of 1982 – 1999, and then again for 1975 – 2012. Their work determined that both increases and declines in home prices impacted household spending, and that the effect was more significant in the second examination period.
Case and Shiller also acknowledged that changes in financial wealth affected consumption over their study timeframes, but to a lesser extent than house prices. This finding was borne out again during 2022: while there was a decline in spending due to the wealth destruction caused by stock and bond losses, it was more than offset by home price appreciation.
However, we think there are several reasons why fluctuations in financial wealth are likely to become a more important driver of consumption, relative to housing wealth, than what Case and Schiller observed. In our view, it is worthwhile for investors to consider those reasons—and the implications this shift may have for how we construct investment portfolios.
Cohorts
One reason for the shift is the transition of baby boomers from being wealth creators to wealth depleters. As baby boomers retire, their consumption is no longer based on their (disposable) earned income, but rather what can be garnered from their sources of retirement funds.
Housing wealth can be tapped for consumption, but the primary source of those funds is likely to be an annuity or a portfolio of marketable securities. In addition, there are indications that even retirees are increasingly viewing financial assets as a potential driver for lifestyle enhancement, not just a source of stable income. A recent study by Vanguard pointed to the high percentage of equities older Americans have in their portfolios, for example.
Another reason is that the demographic cohorts behind the baby boomers are much more likely to have owned financial wealth from an early age. Whereas the average U.S. baby boomer is likely to have bought a house first and then built a securities portfolio later, the average U.S. millennial is likely to have been building a securities portfolio for a decade or more before they bought a house. That raises the prominence of financial assets in millennials’ perceptions of their overall wealth.
Tangible
What is more, the average millennial is much more likely to monitor their financial wealth than a baby boomer was.
The bulk of an individual’s savings is likely to go into a retirement fund. Remember that the wealth effect relies little on any actual increase in disposable income: consumers don’t need to be able to spend their retirement funds today to feel more confident, they just need to be able to see that fund getting bigger.
The reason this is a generational issue is that, according to the U.S. Department of Labor, the number of Americans actively participating in a private sector defined contribution (DC) plan rose from a little over 10 million in 1975 to almost 90 million in 2021, while participants in defined benefit (DB) plans have declined from a peak of around 30 million in the 1980s to around 12 million. Millennials’ DC wealth is much more tangible than baby boomers’ DB wealth was, particularly with digital access enabling savers to watch plan valuations fluctuate day by day. The likes of Zillow and Redfin give homeowners a similar window into the daily fluctuation of their housing wealth, but this is equally true for baby boomers and millennials.
Lastly, millennials are not only in their period of peak wealth creation (with a median age of 40), but now also outnumber baby boomers (as they begin to pass on). Overall, this means there is now more millennial wealth than baby-boomer wealth, which is rapidly translating into consumption as the effects of delayed household formation and the overhang of student-loan debt subside—and that wealth is more evenly balanced between financial and housing wealth, both in reality and in the perception of its owners.
Consumer Psyche
That is why we think there may be an increase, over the long term, in the significance of financial asset prices on the consumer psyche.
This could amplify the feedback loop between financial markets and consumer confidence. It could also have major implications for portfolio construction, by changing our expectations for structural demand for certain assets over the longer term, but also our expectations for major rotations in and out of risk assets at various market inflection points.
Overall, the importance of understanding what really drives the behavior of consumers cannot be overstated—because, unlike the very best theories, they are only human.
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