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U.S./EU: Does Fall In Stock Prices Threaten Economic Recovery?

  • Mark Baker

Stock prices in Europe and the United States are dropping amid a lack of trust in U.S. corporate accounts. That's bad news for the 60 percent of Americans and the smaller percentage of Europeans who own stocks. But the drop in prices may pose a more serious risk to the economic recovery under way on both sides of the Atlantic. Normally, it's the health of the economy that affects stock prices, and not vice versa. But analysts say this time around, the sudden plunge in stock prices may just be enough to wreck a fragile recovery.

Prague, 18 July 2002 (RFE/RL) -- Falling stock prices could pose a risk to the economic recovery now under way in Europe and the United States. That's the opinion of at least some analysts assessing the fallout of a recent downturn in stocks that has seen average share prices drop more than 20 percent this year on both sides of the Atlantic.

In the U.S., the main index of 500 companies, the S&P 500 (Standard & Poor 500), has fallen 21.5 percent this year as investors have fled in the aftermath of a wave of corporate accounting scandals. The scandals have eroded trust in U.S. financial markets, which not long ago were considered the best-regulated and most transparent in the world.

The plunge in share prices accelerated this week in spite of high-profile comments by President George W. Bush and the chairman of the U.S. central bank, Alan Greenspan, designed to shore up confidence in the economy.

The situation is the same in Europe. In London, the main stock index, the FTSE 100, has dropped 23 percent since the start of the year. Stock prices in Germany are off more than 20 percent and in France 30 percent.

To the more than half of all Americans and a smaller but significant percentage of Europeans who own stocks, the drop in share prices comes as bad news. This is especially true for older people with pension plans invested in stocks.

Daragh Maher of the London-based ING Financial Markets, an investment bank, says the share-price collapse could pose a risk to the health of the U.S. and European economies as a whole. "[The fall in stock prices] certainly poses risks to economic recovery. Obviously, people are invested in the stock market to differing extents. A number of people's pensions, etc., are tied to performance in the equity markets. And, in general, the froth [extra income] that had been added to [people's] earnings in the past by rising equity markets is clearly now in substantial reverse. So it does pose a risk. It could damage confidence and could pose a threat to spending," Maher said.

Normally, day-to-day or week-to-week changes in the stock market have only a limited impact on the health of the economy. Equity investments make up a relatively small percentage of the wealth of citizens, who count on wages, interest income, and other investments to cover living expenses. Stock-market investments are generally regarded as long-term, and consumers do not usually defer purchases because of fluctuations in stocks.

Maher said this time, however, the drop in share prices is being driven by what he called a "sentiment shift." This shift may be strong enough to derail consumer confidence, which in turn would derail the recovery. "The mechanism is reasonably straightforward. [A falling] equity market, let's say, driven by a sentiment shift as we're seeing at the moment, could affect the wealth of industry and consumers to such an extent that they spend less, and therefore there's less demand in the economy, therefore less activity. Which in turn would seem to reinforce the fall that you had already seen in the equity market," Maher said.

Greenspan, in his comments to a U.S. Senate banking committee on 16 July, went to great lengths to reassure Americans that their economy, which went into recession last year after almost a decade of continuous growth, remains poised for recovery. "The mildness and brevity of the [recent economic] downturn, as I indicated earlier this year, are a testament to the notable improvement and the resilience and flexibility of the U.S. economy," Greenspan said.

Greenspan added, "The fundamentals are in place for a return to sustained healthy growth."

But even without the sudden drop in stock prices and the collapse of trust in financial markets, that recovery was never expected to come quickly or be robust. Most analysts foresee only around 2 percent growth this year in the U.S. and just 1 percent in the European Union's euro-zone.

ING is maintaining its modestly positive outlook for economic recovery, both for the U.S. and the euro-zone. Maher says consumers, despite the drop in share prices, are continuing to spend. And he says economic fundamentals, like low inflation, are in place for a recovery.

He listed the reasons why he believes Europe is poised for a rebound. "Initially, an improvement in exports, which is already evident. Secondly, corporations in Europe have run down their inventories, or their stocks, to such a level that now that demand has improved they need to begin boosting production. The third factor is that inflation is low in Europe at the moment, which provides a boost to real incomes to consumers," Maher said.

Maher's optimism is not shared by everyone. Stefan Schneider at Germany's Deutsche Bank said his group is now in the process of downgrading its economic forecasts for Germany and the euro-zone. He said he's disturbed by the drop in share prices and the direct impact that has had on the value of the U.S. dollar.

The dollar this week dropped to parity with the euro for the first time in more than two years. The decline was caused in large part by European investors' abandoning the U.S. stock market, selling their dollar-denominated assets and buying euros.

Schneider said a stronger euro will hurt German companies' ability to export outside the euro-zone. Since Germany is the euro-zone's largest exporter, what hurts Germany hurts the euro-zone as a whole. "All the forecasts for a euro upswing call for an export-led recovery. There's no one saying there's a tremendous rebound in one of the components of domestic demand that would trigger the overall economic recovery. So I think [the fall in the dollar] is important and we're in the process of revising downward our numbers for Germany [and for the euro-zone as a whole]," Schneider said.

He conceded the outlook is not entirely bleak. Interest rates in the U.S. and Europe are likely to remain low for the foreseeable future. This, coupled with low inflation, is a textbook formula for economic growth.