There is a common notion that when the stock market is rising, people tend to spend more because they feel more financially secure when they see the value of their investments increasing.
But when share prices start to fall, people tend to spend less because the decrease in the value of their investments makes them poorer.
This psychological phenomenon known as the “wealth effect” states that fluctuations in share prices, as a result of changing consumer confidence, can affect the level of spending in the economy.
In 1957, a Jewish-Italian economist by the name of Franco Modigliani explained under his theory called Life Cycle Hypothesis, that while households increased their consumption when there was an increase in wealth income, they did not spend it as much as the increases from their regular earnings.
This is because households consider gains from investments as temporary income, which they spend slowly over their lifetime.
For example, if we are going to follow this model by doing a simple regression using the actual data of household expenditures and the Philippine Stock Exchange index (PSEi) for the past 19 years, we can find that households on the average will spend only 8.4 cents for every one peso increase in stock market wealth.
This differs significantly if we compare it to a one peso increase in regular disposable income where households will spend 10 times higher at 85 cents in additional consumption.
Although the “wealth effect” of 8.4 cents may look small, the impact on private consumption could be in the billions of pesos. A 1-percent increase in the PSEi could translate to an additional household consumption in the economy of roughly P68 billion.
Now, it is also interesting to see that the degree of “wealth effect” can change depending on the trend of the market.
During the bull market period of 2003 to 2007 when the PSEi increased by more than three times, the marginal propensity to consume by household per one peso increase in stock market wealth was 13.8 cents.
But during the financial crisis from 2007 to 2009 that followed, when the stock market lost almost half of its value, the wealth effect on loss of consumption was a huge 41.5 cents per one peso decrease in equities investments.
The decline in the stock market in 2009 slowed down total household spending to its lowest growth rate at 4.2 percent against its average historical growth rate of 10.7 percent.
During that same year, when the financial crisis ended, the stock market began a multiyear bull run that saw the PSEi increased by almost five times at its high in 2018.
The rise in the stock market created a wealth effect on consumption of 15.5 cents for every one peso increase in equities, which helped increase total household expenditures in the economy to double in less than a decade, growing at an average rate of 8.9 percent per year.
When the PSEi topped out in early 2018, total household expenditures also peaked that year with a record growth of 10.9 percent.
But in the following year, as the stock market struggled to stay afloat, consumer spending began to slow down at 7.8 percent growth in 2019. Total household expenditures in the fourth quarter also had the lowest growth in ten years at 6.7 percent.
This year, following the outbreak of coronavirus, the fall in the stock market has caused households to cut down spending by 30 cents for every one peso decline in stock market wealth, resulting to 7.8-percent drop in real private consumption.
While it is good to know that a rising stock market, being a leading indicator, can signal positive changes in the economy, a falling market can also do the same on the negative side.
Recent market history has shown us that the impact of wealth effect of a falling stock market on consumer spending is twice as strong as a rising market.
If the current pandemic continues to dampen market sentiment, a further collapse in the stock market may possibly result to more losses in the economy. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 86th batch of RFP Program this October 2020.
To register, e-mail info@rfp.ph or text at 09176248110