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For Markets, Good News Is Good News Again

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For Markets, Good News Is Good News Again

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For Markets, Good News Is Good News Again
For Markets, Good News Is Good News Again

This is a big change as the S&P 500 fell from Christmas until mid-January when inflationary risks eased. Stocks tend to rise when bond yields fall, which has been the norm for most of this century.

In other words, economic growth is good because it means high profits, and growth is bad because it means high inflation. Unfortunately for investors, there are many reasons to believe that this return to normality may not be sustainable.

Before entering, carefully study the interface. In the 10 trading days since Friday, stock and bond returns have moved in the same direction for all but one, the closest correlation since the brief recession in May 2022. After being mostly negative last year, it rose to 80% in the same period. (Monday and Tuesday are reversed again.)

This parallel rise and fall in stock and bond yields continued for most of a century, ending abruptly last year. This has made life much easier for investors by reducing volatility and making money. A standard portfolio of 60% stocks and 40% bonds will yield the same return because stock and bond prices move in opposite directions every day, and both are profitable in the long run. The trend reversed last year when prices moved in the same direction, i.e. bond yields rose when stocks fell and vice versa, and both declined sharply over the year. It would be great to bring back the old model.

Although you can wish. Admittedly, there is a less obvious reason for rising bond yields than a few months ago due to inflation, the opening of China and a mild winter in Europe.

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But changing the stock-to-bond ratio requires the belief that inflation has been beaten. The market is outperforming economic data and it's easy to see how disruptive the new regime could be.

The first test will take place on Wednesday, when the Federal Reserve raises interest rates for the first time this year. An increase of 0.25 percentage points is expected from the previous estimate of 0.5 percentage points, so the tone of Chairman Jerome Powell's press conference will be critical. Does this mean that inflation is slowing down?

The biggest uncertainty concerns wages, which has raised concerns about the Fed's self-sustaining inflation. Wage growth has slowed and job vacancies have fallen, supporting the argument that there is little fear. But even as unemployment remains at a 50-year low, there are still 4 million more jobs than the unemployed, and while wages are rising faster than ever, they are still rising too fast for the Fed. In addition, they are rising faster than the Fed's inflation rate, which can eat into corporate profits.

All of this affects how we should take good news from the global economy, which prompted the International Monetary Fund to revise its growth forecast on Tuesday. Added to this is the discovery of China.

A strong economy should only be good for stocks if strong growth doesn't mean higher inflation. At the moment, investors do not consider inflationary pressures manageable, or at least they do not think so. As a result, economically sensitive cyclical stocks have outperformed defensive stocks since late December.

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Maybe we will magically achieve non-inflationary growth. It is possible that the impact of last year's price hike after the sharp downturn in the economy will ease pressure on stronger-than-expected growth. However, it seems more likely that inflationary fears will return in the not too distant future and that stock and bond yields will move in opposite directions again.

Email James Mackintosh at [email protected]

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