Last week brought lots of bad news about the American economy.
The stock market treated each new data point suggesting that activity was slowing down as bad news.
And that, in itself, is bad news.
Here’s why: Grim tidings for the economy aren’t necessarily so bad for investors, because they tend to lead to lower interest rates. That, in turn, makes it cheaper to invest and justifies paying a higher multiple for stocks. Growth that is too strong can mean higher rates, and that’s a problem. Hence equity investors yearn for “a Goldilocks economy” – one that is neither too hot nor too cold.
So it makes sense that bad news about the economy is often treated as good news for the markets. But that changes when investors truly fear a recession. In that situation, central banks will make money much cheaper, but that doesn’t counteract the damage to stocks and bonds inflicted by the economy. With bad news plainly treated as bad news, the stock market has reached the point where fear of a recession is its greatest concern.
For the first few years after the financial crisis, with the advent of quantitative easing, the stock market behaved like the giant plant in Little Shop of Horrors. Its constant demand to the Fed was: “Feed me!” And as new waves of central bank asset purchases made money cheaper, share prices rose.
Any stabilisation in the Fed’s campaign to buy assets would stall the stock market. From 2008 until 2015, when the Fed started to get serious about its desire to normalise and raise rates, the S&P 500 rose in line with the Fed’s balance sheet. Bad news, persuading a reluctant central bank to keep buying assets, was good news.
Since then, the relationship has been more complicated and more variable. John Velis, foreign exchange strategist at BNY Mellon, offers the following simple measure of whether good or bad news is treated as such by the market. It shows the correlation between moves in the stock market and moves in Citigroup Inc.’s US Economic Surprise index, which is fixed so that it will rise when economic data is surprisingly good, and fall when it is surprisingly bad. When the correlation is positive, good news is good news (and bad news is bad news). When the correlation is negative, the market is hoping for bad news.
Put differently, when the line is above 0 in the chart, showing a positive correlation, the market is chiefly worried about a recession; and when it is below 0, it is chiefly worried about the Fed monetary policy being too tight. The correlation swings frequently, but at present it is as strong as at any point in five years. So markets really want to hear good news about the economy, even if that means they will have to do without cheap money from the Federal Reserve.
That correlation remained strong through the week. Stocks sold off after bad news from manufacturing and services surveys earlier in the week, and then staged a rebound after broadly strong payrolls report, which showed that the unemployment rate had almost reached an all-time low. And that gain came even though the jobs release caused bond investors to reduce slightly their forecasts for interest-rate cuts.
There have been other sharp sell-offs over the last year, but they weren’t driven by the data as last week’s was. In December, investors were terrified by Fed Chair Jerome Powell’s determination to push ahead with higher rates, while shrinking the central bank’s balance sheet “on auto-pilot”; and the sell-off this summer was driven by escalating hostilities between the US and China over trade.
It’s clear investors are now much more worried about the prospect of an economic slump than they were even six months ago. The inversion of the bond yield curve during the summer (meaning yields on short-term bonds rose above yields on long-term bonds) unnerved many by sending a classic recession signal. The trade wars, worries about a slowdown in China, and a serious slump for German manufacturing have all made a downturn far more plausible.
History also argues that stock-market investors would be wise not to wish for any more rate cuts from the Fed. Over history there are a few examples of “mid-cycle adjustments” – in the phrase Powell used earlier this year – where the Fed cut rates two or three times and managed to prolong an economic expansion. There are no precedents for the Fed cutting by a full percentage point or more without a recession following soon after. And there are also no precedents for a recession that is unaccompanied by a bear market in equities.
The Fed has already cut rates by 0.5 percentage point so far this year. Bloomberg’s estimates show that the market is pricing a fifty-fifty chance that it will have cut by a full percentage point by the end of the year. That would be bad news for everyone.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator