How the Stock Market Downturn Affects Consumer Spending

It’s well known that the stock market responds to changes in consumer spending. However, during the economic difficulties of the last several years, it’s also become apparent that the relationship may work the other way too. Moreover, a stock market downturn affects consumer spending as nervous consumers put off big purchases until the trend passes.

The stock market is, at least in theory, a collective educated guess about what’s going to happen to publicly traded companies in the future. For that reason, investors are sensitive to new reports that consumer spending is changing. In June 2013, for instance, Jeff Reeves warned in the Wall Street Journal’s Market Watch that new research showed American consumer spending was likely to decline over the course of the year and that stock prices might take a beating accordingly. In contrast, earlier this year, the Canadian Press reported that stock markets were rising on the news that American consumer spending was increasing. Boosting consumer spending was one of the ways in which policy-makers hoped the U.S. and Europe could grow their way out of the 2008-09 recession.

But forecasting grows much more complicated if the relationship works the other way, too – that is, if consumers adjust their spending based on what they see happening on the stock market. That was an idea explored by an economist at the Federal Reserve Bank of Kansas City, C. Alan Garner, more than 20 years ago. At the time, economists were divided on whether there was a relationship. Some thought consumers would cut back spending in response to a stock market crash, fearing that their jobs and life savings were in jeopardy and choosing to hold back on some big purchases until their future looked safe again. Other economists thought that because working families aren’t the dominant investors in the stock market, consumer spending probably wouldn’t be all that affected by a stock market downturn. Analyzing the stock market crash of 1987, when the Dow Jones index fell by over 22 percent in just a couple of weeks, Garner concluded that the crash probably had affected consumer spending, but only slightly.

In response to the new economic malaise gripping the West, two University of Ottawa economists recently took a new look at the evidence. Lilia Karnizova and Hashmat Khan believe that the effect of the stock market on consumers’ invested life savings – the issue that economists were thinking about in the 1980s – is really only part of the story. The more important part, they suggest, is consumer confidence. For the average person, they write, “stock market prices are a readily available leading indicator of economic activity.” When stock prices go up, consumers feel more confident about the future, and may spend more accordingly. When stock prices go down, they grow more fearful and try to save their money in case things take a turn for the worse. Karnizova and Khan think people probably go through these changes in confidence whether or not they own stocks, because they’re not just reflecting on the balance of their retirement savings: they’re also using the stock market to gauge whether their job prospects, and the economy as a whole, are likely to be good or bad over the coming years.

Research will probably continue for quite some time, but for now, economists do believe that the stock market downturn affects consumer spending. They’re just not sure exactly how, or by how much.