How the Stock Market Affects GDP

The stock market is often a sentiment indicator and can impact gross domestic product (GDP). GDP measures the output of all goods and services in an economy. As the stock market rises and falls, so too, does sentiment in the economy. As sentiment changes, so do people's spending, which ultimately drives GDP growth; however, the stock market can have both negative and positive effects on GDP.

Understanding How the Stock Market Affects GDP

Before we can determine how the markets impact GDP, we must first review what drives growth in an economy. The U.S. economy's GDP is primarily driven by spending and investment. GDP is typically shown as a percentage growth rate from one period to another.

For example, the quarter-to-quarter growth rate might be 2%, meaning the U.S. economy grew by 2% in that quarter on an annualized basis. Below are a few of the key components that make up GDP:

• Consumer spending; which is the primary driver for GDP in the U.S.
• Business spending includes purchases of new plants and equipment, hiring, investing in new technologies, and building new offices and factories.
• Exports are sales from domestic companies to customers internationally.
• Government spending includes building roads, bridges, and subsidies for industries, such as agriculture.

Together, all of the above, can also be influenced by investors—either negatively or positively—through the stock market.

How Bull Markets Affect GDP

A bull market is when the equity markets are rising. The stock market affects gross domestic product primarily by influencing financial conditions and consumer confidence. When stocks are in a rising trend—a bull market—there tends to be a great deal of optimism surrounding the economy and the prospects of various stocks.

If companies issue new shares of stock to raise capital, they can use those funds to expand operations, invest in new projects, and hire more workers. All of these activities boost GDP. During a bull market, it's easier for companies to issue new shares since there's a healthy demand for equities.

If GDP is rising—meaning the economy is performing well—those same companies can also raise additional funds by borrowing from banks or issuing new debt, called bonds. The bonds are purchased by investors, and the funds are used for business expansion and growth; also boosting GDP.

With stock prices rising, investors and consumers have more wealth and optimism about future prospects. This confidence spills over into increased spending, which can lead to major purchases, such as homes and automobiles. The result leads to increased sales and earnings for corporations, further boosting GDP.

How Bear Markets Affect GDP

Conversely, when the stock market is falling—a bear market—it means that stock prices are going lower, and it can have a negative effect on sentiment.

In a bear market, investors rush to sell stocks to prevent losses on their investments. Typically, those losses lead to a pullback in consumer spending, particularly if there's also the fear of a recession. A recession is often defined by two consecutive quarters of negative—or contracting—GDP growth.

Once consumers begin to pull back spending, it can hurt the sales and revenues of companies. Companies, in turn, are forced to cut costs and workers. The fall in consumer spending is exacerbated by an increase in unemployment and further uncertainty about the future.

Also, businesses might find it difficult to find new sources of financing, and with less revenue coming in, existing debt can become more challenging to manage.

All of these factors lead to a drop in consumer and business confidence, which translates to less investment in the stock market. The contracting spending and investment due to lower confidence ultimately have a negative impact on GDP.

Special Considerations

The stock market's impact on GDP is less discussed than the effect of GDP on the stock market. When GDP rises, corporate earnings increase, which makes it bullish for stocks.

The inverse occurs when GDP falls, leading to less spending by businesses and consumers, which drives the markets lower; however, whether it's a bull market or bear market, the stock market has some level of impact, albeit indirectly, on GDP and the economy as a whole.

The Bottom Line

The stock market is an indicator of sentiment in an economy that can have an impact on gross domestic product (GDP). When the stock market is doing well and growing, it indicates that companies are doing well and will continue to do so. This creates optimism in both consumers, investors, and businesses.

These entities hire more workers, thereby reducing unemployment, borrow money, which has various positive consequences, and with more money and more individuals employed, more spending occurs, further strengthening the cycle and improving GDP. When the stock market is doing poorly, it has an opposite effect to the above.