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Economists studied this phenomenon for years and came up with the theory known as the “wealth effect.”
It states that when things like housing prices and stock prices rise, consumers and businesses spend more money even if they have no increase in disposable income.
Imagine owning a home that was worth $200,000 and it’s now worth $400,000. Even if you still make the same amount of money as before, and even though there aren’t actually more dollars in your bank account, you feel wealthier and thus spend more.
The same thing applies to everything we own, with home prices and stocks leading the charge.
The Federal Reserve measures this through household net worth, which is the total value of all a household’s assets, both financial and non-financial, minus any open liabilities.
The chart above shows how household net worth increased almost constantly over the last decade, with a small downturn in 2019 and in 2020 as a result of equity market pullbacks.
Today, just like with those downturns in 2019 and 2020, we are seeing household net worth edge down as the stock market drops and real estate values rise.
However, with the Fed in full hawk mode, I don’t expect home prices to continue their upward trend forever. And that could strongly affect how the economy behaves from here… and what the Fed decides to do about it.
How Housing Impacts the EconomyDuring the Great Recession, we saw the outsized impact housing has on the global economy.
Housing is the most expensive item consumers purchase on credit. Thus, when it loses value that is realized through a sale or repossession, it becomes a major problem.
Fortunately, today’s borrowers are infinitely more creditworthy and banks much better capitalized than they were back then, so it’s very unlikely that we’ll see the extremes that fueled the last collapse.
The silver lining to an expensive housing market is that everyday consumers use home values to gauge their wealth more than any other asset.
Home ownership is a symbol of the American Dream and for many, the single greatest store of wealth over a lifetime.
So when home prices decline, people pull back on spending. And current trends indicate that a decline may be on the distant horizon.
Prices are continuing to climb for now, but last month’s new residential sales plunged to pre-pandemic levels.
More recently, existing home sales have dropped 3.4% since April and 8.6% since the year before.
This decrease in sales implies that buyers are stepping back from the market as higher mortgage rates and home prices make ownership less affordable.
And while homeowners may have higher-valued properties, it doesn’t do them much good when buyers are scarce. The value is merely “paper wealth”; they can’t realize those gains until they actually sell their home.
The good news here is that slower home sales can dampen consumer demand far faster than any other asset, and decreased demand will help bring inflation in check.
That’s part of how the Fed can drive down inflation without actually putting the economy into a recession.
If people stop purchasing on their own accord because they’re worried about the state of their bank accounts, that can leave the Fed more freedom to end fiscal tightening sooner rather than later.
So what does this mean for investing right now?
I’m focused on managing risk in the short term while keeping an extensive watchlist of equities I see as too far oversold and pounding the table on finding income-generating stocks that have strong moats.