To Markets, Good news Mean Good News

Markets’ economic growth is good because it means higher profits, rather than growth is bad. After all, it means higher inflation, reports WSJ Print Edition. Unfortunately for investors hoping that they can return to business as usual, there are plenty of reasons to think this might not last.

Before getting into them, look more closely at the shift. In the 10 trading days up to Friday, stocks and bond yields moved in the same direction on all but one day, the tightest link since the brief recession panic in May 2022. The correlation between the two, a mathematical measure of how closely they are in sync, leaped to 80%, after being negative for most of last year. (On Monday they moved in opposite directions again, though early on Tuesday stock futures and bond yields were falling together.)

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This pattern of stocks and bond yields rising and falling in parallel held for most of this century until breaking decisively last year. It made life much easier for investors, dampening volatility while making money. The standard 60% stock, 40% bond portfolio smoothed returns as stocks and bond prices tended to move in opposite directions on a day-to-day basis, while over the long run, both made money. Last year the approach was crushed, as prices moved together—that is, stocks fell when bond yields rose, and vice versa—and both fell heavily over the year. It would be great if the old pattern was back.

It might be wishful thinking, though. True, there are clear justifications for stocks to be higher and bond yields lower than a few months ago, as inflation has come down, China has reopened and Europe’s mild winter has eliminated fears of energy shortages.

How Well Are The Markets?

But the shift in the stock-bond link requires a belief that inflation has been vanquished. The markets are well ahead of the economic evidence, and it’s easy to see how the new regime could be upset.

The first test comes on Wednesday, with the first Federal Reserve rate rise of the year. It’s widely expected to lift rates by only 0.25 percentage points, down from past 0.5-point hikes, so the key will be the tone of Chairman Jerome Powell’s press conference. Will he nod to the idea that inflation pressures are abating?

The biggest doubt in Markets is about wages, the heart of the Fed’s concern about self-sustaining inflation. Wage growth has moderated and job openings have fallen, supporting the argument that there’s less to fear. Unemployment remains at 50-year lows, there are still 4 million more jobs on offer than there are unemployed workers, and while wages are rising more slowly than they were, they’re still rising far too fast for Fed comfort. They are also rising faster than the Fed’s preferred measure of inflation, which could eat into corporate profit margins.

All of this affects how we should think about the good news for the world economy, which on Tuesday led the International Monetary Fund to upgrade its growth forecasts. That comes on top of China’s reopening.

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A stronger economy should only be good for stocks if stronger growth doesn’t mean more inflation. For now, investors believe it doesn’t, or at least that any extra inflationary pressure will be manageable. This is why cyclical stocks sensitive to the economy have been outperforming defensive ones solidly since late December.

last year’s rate rises, which tend to hit the economy after a significant lag, will precisely counter the upward pressure of unexpectedly strong growth. But it seems more plausible that inflation fears will return in the not-too-distant future, and stocks and bond yields will start moving in opposite directions again.

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