MARKETS SPECTATOR: Welcome back wealth

The 'wealth effect' is said to be the most important factors in determining consumer spending so the house price turnaround, coupled with bullish equities, bodes well for the economy.

An important theme that’s started to receive some airtime recently is that of the 'wealth effect' and the impact it could have on the market and economy over the next 12 to 18 months.

The sectors of the economy linked to consumer spending account for a huge chunk of GDP. In fact, it’s well known that 70 per cent of US GDP comes from consumer spending. Australia’s not that reliant on it but nevertheless, it’s a big chunk.

Research from academics, the RBA, IMF and numerous financial institutions all show that consumer spending is basically driven by three main factors; the growth in households’ income, their confidence and their wealth.

Of these, the wealth effect is said to have the biggest impact on consumer spending. Drilling down even further, housing assets have a greater importance over equity assets in terms of their relationship to consumer spending.

In a research paper titled Housing Wealth, Stock Market Wealth and Consumption: RBA RDP, July 2003 it was noted that: "a 1 per cent increase in housing wealth has an effect on aggregate consumption that is at least as large as that of a 1 per cent increase in stock market wealth.”

Also, in another piece from the IMF World Economic Outlook in April 2003, they found that "busts in housing prices have had a larger negative impact on these macroeconomic variables than busts in equity prices”.

It’s well known that over the last three to five years, there’s been a powerful negative force confronting the household sector across much of the developed world, including Australia. Falling house prices and slumping global equity markets acted as a very strong counterbalance to the lower interest rates that were delivered to consumers via the aggressive monetary easing that occurred almost globally.

Many believe that Australian households have faced the two most significant collapses in wealth since at least the mid-1900s over recent years.

Now it looks like the ship is turning. Since mid-2012, we’ve seen a strong rally in global equity markets and more importantly for consumers, the housing market looks to be gathering momentum, too. According to UBS, US house prices have lifted 6 per cent over the past year, while Australian prices have recovered from minus 5 per cent year-on-year to be up 2 per cent year-on-year.

Consistent with the findings from the RBA and IMF, the below two charts show a significant link between household wealth and saving, with rises in household wealth leading to a lower savings rate, and vice versa.

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So, in short, after a number of years in which consumers have been faced with drastic downturns in their wealth, they are starting 2013 well and truly on the front foot as recoveries in equities and housing markets continue to take hold.

This is likely to be another important positive for economies and consumers in 2013.