Government monetary policy from both Republicans and Democrats is governed by the economic philosophy of John Maynard Keynes.
Keynes was a member of the infamous Cambridge men's society "The Cambridge Apostles." Don't let the name fool you: they referred to the apostles in a mocking way. The group was thoroughly committed to atheism. In fact, they once had a debate, as a group, about whether they would admit God to their exclusive club, if He were to apply for membership. After a debate of the members, they concluded that God was not up to their standards and would not be acceptable as a member. They chanted "God out! God out!" in response.
The market chaos we see now is what happens when "God out!" becomes the philosophical consensus of our central bank apparatus. When Ben Bernanke was nominated, the Bush administration sent the Chairman of the Council of Economic Advisors to lobby me to support his appointment. I asked how Bernanke would respond to slow growth, and he told me: by pursuing easy money. I asked him how he would respond to inflation, and he told me: by tightening money which would slow the economy from 'overheating'. In other words, he told me that Bernanke would be a Keynesian. And so he was. And so have been his two successors under a Democrat, and then a Republican, and now another Democrat administration.
They blew the biggest financial bubble in our history and now we are suffering under both the inflation which came from that, and the need to pop the bubble in the fight against inflation. This vacillation on a weekly basis between the desire to fight inflation by slowing the economy, and then to fight the slowing economy by going back to inflationary policies, is at root built into the Keynesian approach and its rejection of God from its economic and social club.
Big Picture: Last week's investor behavior seemed largely to be driven by the Fed meeting. The Fed raised its target rate by .75%, just as the futures market implied it would. The Fed also indicated that its next rate hike would be .5%. The futures market also knew that already. So, if the Fed did what the market expected, why did the market react by selling off? Because the Fed also made comments indicating it would probably continue to hike rates more and longer than markets had previously thought. In other words, it told markets, "You have correctly anticipated the policy for two meetings, but you have been underestimating our willingness to keep tightening after that."
Of course, remember that the Fed does not literally raise and lower rates. They just indicate that they're going to sell or buy bonds. The changes in rates are a byproduct of either creating money and using it to buy securities, or selling securities and destroying the monetary proceeds of those sales. The actual operation is either money supply expansion which is injected into markets, or contraction of money supply as it is pulled out of markets. That's why Fed activity is so important to markets: it is a direct intervention into them. The reason Fed activity is getting to be even more important to markets is that in the past 14 years it has become a much larger financial entity, its size dwarfing any other single investor.
So, the Fed meeting signaled a longer period of selling bonds and contracting money supply (aka 'hiking rates'), which caused the now familiar list of trades that occur when the Fed sends those signals:
- Gold fell.
- Bitcoin fell.
- The dollar rose.
- Futures markets signaled larger Fed hikes in the future.
- Futures markets indicated that the Fed would delay cutting until later.
- Bond yields generally rose.
- Most stock markets fell, and fell more than bonds.
- Inflation-hedged bonds underperformed non-inflation hedged bonds.
- REITS fell, performing better than most stocks but worse than most bonds.
Those trends reversed somewhat on Friday after the employment report, but not enough to counter what happened the rest of the week. For example, gold was significantly down for the week, rose a bit on Friday after the Employment report, but not enough to offset the losses for the week. So, by the end of Friday, the Fed tightening trade was the dominant story of the week, but muted somewhat by the reversals on Friday. We mention this little wrinkle not to make things complicated, but to illustrate the fact that the environment is so volatile that the 'story of the week' really can change in a single day. We can be 'risk off' Monday through Thursday but 'risk on' on Friday.
The Fed tightening pattern usually involves three elements:
First, in general markets fall because the assumption is that the central bank will be pulling money out of markets. If the world's biggest investor is going to sell, that's likely to push prices down. Second, since the process of pulling money out of markets also involves erasing that money from existence, the process is also anti-inflationary. Therefore, inflation hedges such as gold, foreign currencies, inflation-protected bonds and cryptos tend to fall. Third, contracting the money supply and raising interest rates tends to slow the economy because it makes credit harder to get, which contracts both business production and consumption. Therefore, a shift in expectations towards tightening tends to cause valuation contraction, as well as anti-inflation and anti-growth trades.
So far, we've looked at the responses of different asset classes (meaning broad categories such as stocks vs. bonds vs. currencies). These comparative returns between asset classes are consistent with the following account: the Fed is going to hang tough longer and be more aggressive in fighting inflation and therefore will probably be somewhat more successful in lowering inflation. The downside is that it may crash the economy. Even if Fed tightening does not trigger an official dictionary definition recession (six months or more of negative growth), it is still likely that it will at least trigger a "growth recession" (a period of substandard economic and profit growth).
Below, we'll look comparative returns within those asset classes, for example the returns of various sectors within the stock market.
This coming week there will be a number of data releases, but the big item is likely to be the Consumer Price Inflation report. We'll also get a look at other inflation-related data such as wages and consumer sentiment. If inflation is higher than expected, then the Fed tightening trades are likely to continue. If lower than expected, then last week's trades are likely to be reversed. There is no apparent reason to believe there will be a break in the pattern in which the Fed oscillates back and forth between its conflicting dual mandates. And therefore, there is no compelling reason to believe that the markets also will stop oscillating back and forth between the trades appropriate to whichever mandate investors conclude the Fed will be chasing at any given time.
U.S. Real Estate Markets: REITS performed negatively, which one would expect given the prevailing themes of the week: rising rates, falling inflation risks and deteriorating 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. REITs performance is typically situated between that of equity markets and bond markets, which is what happened last week.
U.S. Stock Markets: 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 dropping, because low growth presumably makes it harder for earnings to actually deliver on growth companies' high expectations. So, the lagging 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 was hit harder than value.
We've seen that often in the past, as the U.S. was seen as a haven, we saw not just a shift towards US markets, but also within the U.S. markets, a shift towards growth trades. The relationship also works in reverse. If markets have reached doubts about the U.S. as a haven, they might also be moving away from the high risk/high return sectors and styles. That is what we saw last week: the U.S. lagged global markets considerably (more on that below).
If we're not as much of a haven as markets have believed for most of the year, that means not just that capital tends to get pulled out of the U.S. but also that it gets pulled disproportionately out of the riskier part of the country.
The difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, et cetera, also 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 harder landing picture.
International Stock Markets: International equity markets were mixed for the week. In general, global stock markets had higher price returns than domestic ones. 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 are developing doubts about the U.S. as a refuge from the global recession.
In addition, EM was generally positive and significantly beat DM. This was led by Emerging Latin America, which is likely related to the rise in commodity prices and to the possibility of a better global growth outlook. For most of the year, domestic and global markets have been falling, indicating a general economic pessimism, but for most of the year the world dropped more than the U.S., indicating the markets were somewhat less pessimistic about the U.S. than global markets. But in the past month that seems to have been reversing a small amount. Perhaps the cause is that the Fed has been so unsuccessful in fighting inflation that it will have to tighten enough to drive the U.S. intro recession along with the rest of the world.
EM currencies were roughly even with the dollar, and significantly outperformed developed market currencies. That obviously helped EM performance.
Bonds: Bond markets were generally down last week, which fits the narrative of the week - the Fed will sell more bonds.
But the real story is found by comparing different types of bonds, at individual sectors. The story was consistent with the lower growth outlook, with high yield bonds and investment-grade corporate bonds significantly underperforming treasuries.
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.
In general, markets are responding in rational ways to irrational government policy.
Jerry Bowyer is financial economist, president of Bowyer Research, and author of “The Maker Versus the Takers: What Jesus Really Said About Social Justice and Economics.”