One of the hard lessons of life is that bad decisions have consequences, and that those consequences don't vanish just because we change course and start moving in the right direction.
A good example would be substance addiction: if one takes an addictive substance for an extended period of time, life will spin out of control and great damage will be done. The only wise course is to stop taking the narcotic. However, ceasing the narcotic is not the end of the suffering. In many ways, it is the beginning of the suffering. Withdrawal is painful and difficult. As a general rule, there is no easy way out, just the struggle of recovering from the addiction "one day at a time."
Monetary debasement is a lot like addiction: easy money is pleasurable at the beginning. It causes investment values to rise; it fills the people's bank accounts, and it allows greater consumption of goods and services. But over time, it creates many problems, including inflation. It also creates bubbles in various sectors of the economy. If government policy tries to stimulate housing and the central bank pumps money into the system, we can get a housing bubble, because we build more houses than we should have. Before that it was tech companies. Easy money doesn't just debase the currency, it sends a false signal through the market, telling it to build more of something than is really needed.
The bubble feels good (especially if one works in the bubble industry), but all of that pleasure is really deferred pain, because eventually realty reality will reassert itself and massive layoffs will inevitably follow. Predictably, politicians and other ignoramuses will blame the market for what they themselves did.
Right now, we're in withdrawal: we're trying to kick the addiction of easy money. The Fed created a massive bubble in markets: a housing bubble and easy money, plus COVID lockdowns, created a bubble in social media, ecommerce, and streaming services. But with all of that came inflation. The Fed has been reversing its decade-long flood of new money in ever so slight ways, and even that has turned out to be painful. Markets look for signs that the Fed will pivot from its new role as a 12-Step Program for Easy Money addicts ("Hello, my name is Ben and I have a problem"), back to party animal. Investors don't want pain. But there is no easy way out of a currency debasement bubble. We saw that in the early 80s most vividly.
Big Picture: Each week investors digest new pieces of financial and economic information. Since the Fed is now the largest investor in financial markets, investors tend to interpret economic news through the lens of what effect it will have on the decisions of the Fed. That's why economic bad news is often financial good news. When the economy shows significant signs of slowing, markets wonder if that means the Fed will shift to the mandate that tries to use easy money to stimulate spending. Since the growth side of the competing dual mandates is focused mainly on the effects of slowdown in employment, investors are particularly attuned to that set of issues.
The other half of the dual mandate is fighting inflation. The week before last, inflation came in lower than expected, and (as we explained in our prior weekly analysis) investors concluded that the Fed might pivot away from inflation fighting back to worrying about growth. Even more important than filtering economic data through the Fed reaction matrix is hearing from Fed members themselves. That’s what drove markets last week.
Alas, last week various Fed officials stepped up to the microphone to denounce rumors of dovish policy and reaffirm its inflation hawk glide path. Remember, 'dove' refers to policy advocates who favor the mandate to keep labor markets strong over the mandate to keep inflation low. 'Hawk' refers to the opposite view. Last week was a Hawk Week and the standard package of hawkish sentiment shifts showed up in markets:
- Gold fell.
- The dollar rose.
- Futures markets signaled larger Fed hikes in the future.
- Futures markets indicated that the Fed would reverse course and start cutting later, i.e. in July rather than in June.
- Some Bond yields fell--this was mixed, not a perfect match for the hawk trade (reasons will be given below).
- Most stock markets fell, generally underperforming bonds.
- Copper, which is widely seen as a growth-sensitive commodity (nicknamed Dr. Copper because it's such a good economic forecaster), fell substantially.
- REITS fell, generally performing worse than stocks and most bonds.
In short, after the Fed members' 'open mouth operations' the anti-growth trades dominated the first half of the week. Toward the end of the week there were some signs of bad economic news (which means good market news), but nothing large enough to overwhelm the hawkish story that dominated the headlines, and the market dynamics.
Remember: Fed policy tends to have direct effects on markets since the Fed is the largest participant in those markets. However, the Fed can also move markets via its expected macroeconomic effects. For example, a tougher Fed is a Fed that is pulling money out of markets, driving down prices. But when the Fed pulls that money out of markets, quite often the Fed also erases that money from existence. So it's not just acting as a seller of investments, it's also acting to contract the money supply.
Investors often associate this contraction with a shift downward in inflation expectations (since "inflation is always and everywhere a monetary phenomenon") and a shift downward in growth expectations (because less money means tighter credit for businesses wanting to expand and consumers wanting to buy). So, the hawk trade often involves a shift in expectations about future growth and future inflation. Last week fit that pattern very well when it comes to comparative returns between asset classes (stocks vs. bonds vs. commodities vs. real estate vs. currencies).
As we shall see below the pattern also appeared very clearly in the comparative returns within asset classes (e.g. one sector of stocks vs. another; one class of bonds vs. another, etc.).
Bonds Last Week: Bond markets were generally up last week, which fits the narrative of declining growth: bonds are considered a recession hedge. On the other hand, if the Fed is going to be tightening, that means it will be a bond seller, which should be bad for bonds, right? So that means that a Fed tightening cycle has elements that could hurt bond prices (like the mass selling of bonds by the central bank) and elements that are good for bonds (like contracting the money supply and triggering a recession). Both things are true.
So, how is one to know which is the driver in any given case? Answer: by looking at how asset classes perform relative to one another. If stocks and bonds both fall, that's likely because the market expects the Fed to pull money out of financial markets, driving prices down across the board. In that case, people sell both stocks and bonds because they think the Fed will be a seller and they don’t want to fight the Fed.
But if stocks fall and bonds rise, that means people are pulling money out of stocks and putting them into bonds, which means they want the safety of fixed income investments. That means that the driver is collapsing growth expectations. It also makes sense to look at what particular types of bonds investors are buying and selling. For example, if investors sell risky high yield bonds and purchase safer treasury bonds, that offers further confirmation that the worry is declining growth.
The growth risk thesis is simple: when business slows down, companies find it harder to make their debt payments. So lower-credit-quality bonds are more likely to default and forward-looking investors sell them now rather than risk being left holding the bag if a company defaults on its debt service payments. That works both ways: higher growth rates help those companies make their debt service payments.
Last week, both of those things happened! People crowded out of stocks into bonds and, within the bond world, crowded out of risky high-yield bonds into safer treasuries. There was an exception to the anti-growth trade: investment grade corporate bonds outperformed treasuries, which is usually a sign of growing optimism. However, there have been some odd dynamics around investment-grade corporates: they've been in short supply. Financially health companies have been doing less borrowing, which makes sense since interest rates have been rising. The higher the rates, the less inclined companies are to borrow. High credit rating corporate bonds can afford to fund their operations without much borrowing because they have cash on hand, which means they can avoid issuing new bonds when rates are too high, which means those bonds are in short supply, which means they become more valuable. That provides a reasonable explanation for why high quality corporate bonds are performing well despite what are otherwise across the board anti-growth trades.
In addition, inflation protected securities performed poorly compared to their non-inflation protected alternatives. That implies less fear of inflation. If investors sell inflation hedges, it is logical to consider it likely they are less worried about inflation. That also fits the hawk trade: if the Fed is going to stay focused on fighting inflation, they might actually succeed…at least a little.
Real Estate Last Week: REITS performed poorly, underperforming both stocks and bonds in general, which one would expect given the prevailing themes of the week: rising rate expectation, falling inflation risks and declining growth outlook. REITS do well with inflation (real estate is an inflation hedge), somewhat well with growth (because in seasons of higher growth renters can afford to pay more, but on the other hand long-term leases can act as a hedge against recession); and low interest rates (because it is a debt-dependent sector). Last week's trading pattern implied that all three of those pro-REIT conditions were less likely to occur than previously thought.
Domestic Stocks Last Week: Domestic equity markets were generally down last week, with growth stocks significantly underperforming value stocks. That underperformance occurred among large, mid and small size company categories. Growth tends to lag value when growth expectations are falling, because low growth presumably makes it harder for earnings to actually deliver on growth companies' high expectations. So, the weak growth performance is consistent with the other anti-growth trades of the week.
Also, growth stocks are more dependent on low interest rates than value stocks, so consequently, they also tend to underperform value stocks when interest rate expectations are rising, because their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings.
Last week, the consensus of markets signaled higher interest rates than previously expected, which is both theoretically and historically bad for growth stocks. Accordingly, growth lagged value.
The difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, etc., generally showed a more pessimistic growth shift.
So, the higher future rates picture was fairly clear in the domestic stock market data, and so was a slightly harder landing picture.
International Stock Markets Last Week: International equity markets were generally down for the week, but not consistently. In general, U.S. lagged global stock markets in price returns. This occurred in spite of a rising dollar. In other words, foreign markets generally performed better than U.S. markets even though their currencies generally performed worse than the dollar. This all suggests markets may be edging back from the idea of the U.S. as a refuge from the global recession. For most of the year, markets signaled that the U.S. might avoid the global recession. So far this quarter, including last week, markets have been less confident that we could avoid the global crash.
In addition, EM was generally positive but DM was negative. The EM exception was emerging Latin America, which was especially hard-hit.