The notion of a slowing economy equating to rising stock prices qualifies as counterintuitive, but that is exactly what we’ve seen over the last few months. Typically, positive stock market performance is aligned with strong economic growth, as seen in the chart below. This makes sense as GDP growth means individual companies are producing more, and earning more, leading to increased valuations and higher stock prices. So, it begs the question – why, of late have we seen markets moving higher on days when we get downbeat economic data?
The answer to this phenomenon is derived from the actions of the Federal Reserve. Remember, the Fed is tasked with maintaining a balance between economic growth and inflation, and for the last 20 months (the start of interest rate increases) this balance has been a delicate one. The Fed began raising rates in March 2022 with the goal of taming inflation by slowing economic growth just enough to keep us out of a recession. After 11 hikes and more than a five percent increase in the fed funds rate, we have seen a sharp reduction in inflation data along with continued growth in the economy.
Now, it hasn’t been all fun and games along the way, particularly in the first half of the cycle when we continued to get strong economic data coupled with red-hot inflation in the face of restrictive monetary policy. Good economic news meant tough times for investors – fixed-income markets took a beating and equity markets wrestled with heightened volatility. Markets were hoping to see cooling inflation and a slowing economy and at that point, we were getting the opposite.
Fast forward to the last few months and we’ve seen several indicators that the US economy is slowing down – the unemployment rate is up slightly and consumer spending has softened. On top of a slowing economy, we’ve seen peak inflation of 9.1% come all the way down to 3.2%. These developments have led many experts to speculate that the Fed may be nearing the end of its interest rate hiking cycle and may in fact begin cutting rates sometime next year. This is the scenario that forward-looking markets have been longing for, and it was brought on by weakening economic data (and obviously, lower inflation).
Here are some examples of how bad news can be good news for the US economy:
- Lower-than-expected job growth: this can signal that the Federal Reserve is doing a good job of bringing down inflation. For example, stocks rallied sharply recently after the Labor Department announced non-farm payrolls rose by 150,000 in October – 20,000 fewer than expected.
- Weaker-than-expected retail sales: this is an indication that consumers are being more cautious with their spending, helping to keep inflation in check.
If the Fed does reverse course and begin cutting rates, it would likely be seen as a positive for the economy, hence the positive market reaction to bad economic data. Lower interest rates make it cheaper for businesses and consumers to borrow money, leading to increased investment and spending. However, the “bad news is good news” dynamic can only be sustained for a limited time. If the bad news is too severe, it can signal that a recession may be on the horizon. On the flip side, if the economy is not actually slowing down as much as we think, then lower interest rates could spark a resurgence of inflation.
Here are some factors that could determine how long this dynamic can last:
- The pace of economic growth – if the economy slows too much, it could tip into a recession.
- Persistent inflation – if inflation remains stubbornly high, the Fed may be forced to raise interest rates more than expected.
- The actions of the Fed – the Fed’s decisions on interest rates will have a major impact on the economy and the stock market.
With an abundance of factors at play, it is difficult to predict how long the “bad news is good news” phenomenon will last. However, what is perfectly clear is that the actions of the Federal Reserve will play a critical role in determining the path forward for the US economy and markets.
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Sources:
Ticu, Paul. “U.S. Real GDP and S&P 500 Price Performance.” Seeking Alpha, 7 Apr. 2015, seekingalpha.com/article/3053626-u-s-real-gdp-and-s-and-p-500-price-performance.
