One of the strange phenomena of financial markets that most of the population who don’t follow
economic data every day may find perplexing is the tendency for the market to, at times, sell off
in response to good economic data and rally in response to bad economic data. One would think
that a higher unemployment rate than expected or fewer jobs created than expected should cause
the stock market to go down, right? Yet often that is not the case. The reason that bad news can
often be good news for financial markets is that the Fed runs something called “countercyclical
monetary policy”.
Countercyclical monetary policy simply means that the Fed’s job is to pursue an economy where
inflation is under control and employment is healthy, through actions that are the opposite of
what is naturally going on in the economy. If the economy is booming and everyone has a job, but
prices are going up, the Fed might hike rates to try to slow down the economy a little and avoid
an even bigger crash (that might happen later, if they didn’t step in). Conversely, if unemployment
is high and the economy is weak, the Fed is likely to cut interest rates to stimulate the economy.
These actions by the Fed can have such a significant impact on companies that the stock market
will sometimes respond more to the perceived next action of the Fed than to the actual state of
the economy.
So, if I told you that in the first quarter GDP was better than expected, corporate profits were
higher than expected, the unemployment rate moved up slightly (but less than many were
projecting), and consumer sentiment moved up, in what direction would you think stocks went?
The answer is that they went up, which seems obvious. However, if you would have given me
those data points at the beginning of the first quarter I’m not sure how I would have answered the
question. I probably would have told you that a stronger than expected economy meant inflation
also didn’t come down as fast as expected, and that would lead to the Fed delaying rate cuts.
Both of those things happened, in fact, and yet the market was still up. Could this mean that even
though the Fed will cut less this year than was originally expected (in January the expectation
was for seven, although we wrote in the January commentary that we thought that many cuts was
unlikely), the market cares more about how the economy is doing, and good news might finally be
good news again?
As I outlined in the first paragraph, there is much economic data to be happy about, but I do have
a reputation for being the pessimist in our office, so let me briefly indulge my less optimistic side.
At the beginning of 2023, when inflation (as measured by CPI) was roughly 6.5%, I wrote that the
path to 4% inflation would be relatively easy, but then the real work would start and getting it
down to the Fed’s 2% target would be exceedingly difficult. Fifteen months later, we sit at 3.48%
and while we can celebrate inflation being 3% lower than it was in early 2023, it’s hard to feel like
celebrating when we have seen three straight months of higher-than-expected inflation, and the
path of disinflation has stalled. I mentioned in the first paragraph that stocks have been resilient
through this economic data, but if you are a more conservative investor, there is a one-word reason
why you aren’t feeling quite as optimistic: bonds. The US 10-year Treasury finished 2023 yielding
under 3.9% and has since climbed to over 4.4% as the odds of rate cuts this year have decreased.
You may not watch the Bloomberg US Aggregate Bond Index as closely as you do the S&P 500,
but if you are a conservative investor, it may matter just as much or more to your portfolio, and it is
down over 1.5% this year so far.
Our view has been that in the short term, yields would rise as we expected disappointment over
the number of times the Fed cut this year, and so we have weighted short-term bonds more
highly, which has helped cushion some of the blow from bonds, but not all of it. It’s easy to feel
negative about bonds at this point, after a uniquely bad three-year stretch, and only being two
years removed from the worst year in aggregate bond history. As hard as it is to feel positively
about bonds, we would still encourage investors to take the long view. We think there may still
be slightly more short-term pain in the bond market, but with yields close to the highs of the last
fifteen years, the opportunity for long-term investors in bonds remains intact. Rate cuts would be
a positive for bonds because when yields go down, prices go up, but with yields where they are
now, bonds can provide positive returns for conservative investors, even if rates stay where they
are. In our financial planning conversations with clients, we have seen expected returns go up
without the need to take on additional risk, now that bonds are providing more attractive yields.
As we look forward, the immediate bitter pill to swallow for both stock and bond markets is that
the rate cuts aren’t coming on the timeline that the market was hoping for. We have already seen
that create some short-term pain for both stocks and bonds and expect that to continue to be
a storyline in the immediate future. If you can take a step back from that though, you will see a
much more positive backdrop. The main reason the cuts aren’t coming is because the economic
data is much better than people were expecting, and the economy is healthy enough to keep
roaring without the need for Fed cuts. As always, there will be specific sectors and industries that
will struggle more than others with this change in narrative, such as real estate and industrials, but
for other areas, such as financials and healthcare, we continue to see more signs of health.
One other area we are seeing some warning signs in is what are called momentum stocks, or
simply, the stocks that have performed well most recently. We have seen a sharp pullback in the
last week, which is an unsurprising development, given the recent run we’ve seen. The good news
is that historically, pullbacks in momentum stocks create opportunities in other areas of the stock
market, and that is what we are focused on currently.
If I haven’t confused you yet, let me try one more time by summarizing the current economic
situation. The bad news is that the economy is healthier than people were expecting, which means
that the Fed will have to do less to support an unhealthy economy. I don’t mean to minimize the
short-term volatility these changes in interest rate expectations can cause, but when you step
back for a moment from the news cycle, you can start to appreciate the perspective that good
economic news is in fact good news.
Executive Summary
• Economic data has overall been more positive than expected to start the year.
• Unfortunately, a faster-growing economy has also led to more persistently high
inflation.
• A stronger-than-expected economy with higher-than-expected inflation means the
Fed is likely to cut less than expected.
• Despite the lack of Fed cuts, stocks still had a positive start to the year, but the
Aggregate Bond Index is negative on the year, which is especially painful for our
more conservative investors with higher bond allocations.
• We do not think it is time to abandon bonds, as conservative investors have the
opportunity to own high quality bonds at close to the highest interest rates of
the last 15 years. It’s been short-term pain for the long-term gain of higher return
expectations on the less risky part of your portfolio.
• There are parts of the stock market that will be impacted negatively by this
change of narrative for interest rates (real estate, industrials, consumer staples, and
momentum stocks) but we are also seeing opportunities in other pockets of the
stock market (financials, healthcare, and high beta stocks).
