Good news is good news again in markets
Stocks sail higher without the fuel of low rates
A strange thing happened last week: calm. Inflation data in the United States showed prices were rising faster than analysts had expected or hoped in February, an outcome that, on the margins at least, bolsters the case for keeping interest rates higher for longer.
At one point last year, “higher for longer” were the three scariest words in the English language for investors, enough to strike terror into any portfolio manager. This time around, however, government bonds wobbled only slightly and both U.S. and global stocks held it together around record highs.
This is a sign that interest rates are shedding their suffocating dominance over global markets, and that stocks are climbing not because they are huffing the speculative fumes of imminent and aggressive potential rate cuts, but because they’re worth it.
We are in a new era where the apparent need to keep interest rates high in an effort to suppress inflation (now running at 3.2 per cent in the U.S.) is a bullish signal for risky assets such as stocks, not a reason to panic.
This is always an unstable little dance in the markets. Sometimes bad news on the economy is good news for markets because it suggests lower interest rates ahead. And sometimes the relationship flips around again. Now we are back to good news being good news.
Well, sort of. You can argue we have been in this era for quite some time, and that in a brutal 2022 and largely brutal 2023, nervy stock investors, spooked by a recession that never came and still blindsided by the supply shocks of the COVID-19 era, misread high rates as a threat, rather than as a sign that the economy was humming along nicely.
This year, by contrast, stocks have proven to be perfectly able to sail higher without the fuel of low rates.
“We’ve seen a breakdown in correlations since January,” Greg Peters, co-chief investment officer at PGIM Fixed Income, said.
“I always felt it to be a spurious correlation anyway.
“The equities folks were worried when rates were going higher without understanding why they were. Today, rates being higher is a byproduct of much stronger-than-expected growth. The market has smartened up.”
Life would be very boring — and markets would cease to function — if everyone agreed with each other. So, naturally enough, doom mongers are still doing their thing.
“Complacency is dangerous,” proclaimed Albert Edwards at Société Générale SA in a note last week. “Now that almost every market guru has walked back their recession call, wouldn’t it be just typical if the U.S. economy now slides into recession?”
Some economic data still look fragile, and echoes with previous run-ups to market shocks are striking, he said. Record highs in stock markets have also “buoyed the economic narrative,” he said. “Something does not look right.”
Something always looks askew to perma-bears such as Edwards, but he does have a point. One recent academic paper argued that animal spirits or bubbles in markets can themselves be responsible for as much as an additional 0.8 percentage points on U.S. inflation rates. Feedback loops like these can make it even harder to predict what’s coming next.
In addition, investors know that markets are on a tightrope.
(Pictet Wealth Management SA has clearly been investing in thesauruses: it has labelled this “the year of the funambulist.”)
A resurgence in growth and inflation strong enough to restart rate rises is unlikely, though impactful enough to take seriously, while the chance of a recession in the U.S., also improbable, also obviously matters.
Neil Sutherland, a fixed income portfolio manager at Schroders PLC in New York, is not in the recession camp, but he does suspect some of the gloss on the U.S. economy will start to fade soon.
“Risk assets could struggle,” he said, and he’s not referring only to stocks.
Sutherland said any deviation to the idea that U.S. inflation will generally keep sinking while the economy holds up “could be a negative scenario, particularly when you look at valuations in credit.” The extra premium that corporate debt offers on top of super safe government bonds is close to its slimmest on record, reflecting runaway demand for this asset class.
Still, the market’s mindset is shifting around higher rates.
“I’m surprised when investors are still so nervous about rates staying high,” Karen Ward, chief markets strategist for Europe at Jpmorgan Asset Management, said.
“Zero-interest rates were a sign of the ill health of the economy. Rates were low because economies were really struggling.
“Good riddance.”
As last week proved, we now know for sure that for stocks to keep demolishing record highs (in nominal terms at least), and for corporate debt to remain so firmly in favour, clearly does not require the U.S. Federal Reserve to cut rates six times, as the market had been anticipating just a few weeks ago.
It might not even hinge on the Fed cutting rates three times — the path it has outlined.
That leaves fund managers able to cheer positive news as and when it lands. Stop worrying and learn to love higher rates.