Goldman Sachs: If Stocks Drop, The Economy Will Too

From Tyler Durden: In addition to boosting the intangible “wealth effect” by raising consumer confidence and encouraging spending, rising stock prices have a benign effect on the broader economy by directly stimulating US economic growth and GDP. And vice versa: when stocks drop, tightening financial conditions, US GDP is impacted adversely.

That’s the observation made in a Friday note from Goldman economists, which tries to quantify the growth effect of the equity sell-off, and finds that “the stock market is likely to turn from a significant contributor to strong growth at the start of the year into a modest drag next year, barring a further rebound in equity prices.”Picking up where another recent Goldman note left off, which as we discussed yesterday concluded that the Fed will have to hike rates more than the market expects in order to substantially tighten financial conditions and slow down the economy, bank  economists Jan Hatzius and Dean Struyven write that “the 6% decline in the stock market since late September has been the most important driver of the recent tightening in financial conditions.” As a result, the bank now estimates “that the 0.5% boost to GDP growth from higher equity prices at the start of the year has already disappeared.”

As shown in the chart above, Goldman explains that the run-up in the equity component, i.e. rising stock prices, of the Financial Conditions Index drove most of the 185 basis points easing from the start of 2017 till late January, when the index hit its record low. Conversely, the 6% sell-off in the S&P 500 since the September all-time high has been the biggest factor in the tightening of financial conditions and has accounted for two thirds of the roughly 50bp FCI tightening over the last month (other factors include the rise in rates and the dollar which account for about half of the -1.5% swing in the FCI impulse from +0.75pp at the start of the year to -0.75pp in the first half of next year).

Looking ahead, between the Fed’s own tightening  posture and potential continuation of the equity selloff, Goldman expects a decline in the equity impulse to real GDP growth to about -0.25% in the first half of 2019. This assumes that the equity component of the Financial Conditions Index stays at current levels, which is “roughly consistent” with Goldman’s forecasts for a 2019 year-end level of 2,850 on the S&P 500 and $159 EPS by end-2018.

Considering the reflexive nature between the stock market and the broader economy, Goldman also looks at the sensitivity of the equity impulse and its growth forecast to future stock market moves, i.e. what happens if stocks rise notably above or below this 12-month 2,850 price target.

First, the good news: should the recent market weakness fade, and stocks rally, Goldman assumes that the S&P 500 can rise about 4% per quarter to 3,350 by end-2019, roughly 15% above the September peak. In this case, the growth impulse from equities will rebound to +0.25pp in the second half of next year, and the continuation of the bull market “will likely keep GDP growth in 2019 well above potential at 2.4% on Q4/Q4 basis.”

Next, the not so good news: should the sell-off continue and stock prices fall an additional 10% in Q4 to around 2,500 and stay flat, some 15% below the September all-time high, Goldman estimates that the growth impulse from equity prices would turn from a neutral factor today to a -0.75pp drag by Q2 2019, as shown in the chart below. According to its calculations, Goldman concludes that such a decline would push GDP growth down to 1.6% in 2019 on a Q4/Q4 basis, below our estimate of potential and well below our 2.0% baseline forecast.

Summarizing its findings, Goldman’s economists warn that “the stock market has turned from a key growth contributor to a roughly neutral factor, and will likely be a modest drag by early next year”… or a substantial drag if equities drop another 10% or more. Which is probably why the bank’s economists appear to have turned somewhat skeptical on their otherwise cheerful economic outlook.

Further sharp stock market moves represent an important two-sided risk to our forecast that growth will gradually slow to potential by end-2019.

What is odd, is that this report came out at the same time as Goldman’s other assessment of Fed hiking risks, which concluded that Powell will hike another 5 times before year-end 2019, or 2 more hikes than the market is currently anticipating. That forecast has yet to change, which begs the question: is Goldman’s latest note confirmation that it will revise its Fed rate hike estimates in the coming days if the selling persists, and, by extension – is the market now on the verge of a steep correction should the Fed keep raising rates?

While it remains to be seen whether Powell will be as easily swayed by market gyrations as his predecessor, the above analysts explains president Trump’s increasingly belligerent posture vis-a-vis the Fed’s tightening plans, because as Goldman’s analysis reveals, any further selling in US stocks will have a prompt, and adverse, impact on strong US growth which has so far been the biggest achievement of Trump’s administration (granted with the benefit of some $1.5 trillion in fiscal stimulus).

In other words, if stocks do tumble, and GDP in early 2019 prints sub-2.0%, below Goldman’s estimate of potential and well below its 2.0% baseline forecast, expect the war between the White House and the Marriner Eccles building to escalate dramatically in the coming months and certainly ahead of the 2020 presidential election. The question then will be whether Powell will end the hiking cycle, or – to indicate the Fed’s independence from the White House – will keep pushing rates higher, until the market cracks far more than just 10%.

The iShares S&P 500 Index ETF (IVV) was unchanged in premarket trading Monday. Year-to-date, IVV has gained 3.97%.

IVV currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 152 ETFs in the Large Cap Blend ETFs category.