In a seemingly paradoxical economic climate, bad news for the economy is becoming good news for stocks, while positive indicators are stirring anxiety. This perplexing market behavior, primarily driven by inflation concerns, is changing the game for investors and might signal a generational shift in market operations. The recent announcement of weaker-than-expected job openings is a case in point; instead of viewing this as a negative signal suggesting weaker demand and dwindling consumer confidence, investors are finding solace in the prospect of a slowdown. The rationale behind this reaction is that a slowdown would alleviate pressure on the Federal Reserve to hike rates, leading to a drop in bond yields and a rise in stock prices.

For much of the 20th century, barring periods of significant upheaval like the Great Depression, World War II, and the Vietnam War, stocks and bond yields traditionally moved in opposite directions. However, this pattern has been upended in recent years, with investors growing accustomed to stocks and bond yields moving concurrently from 2000 to 2021. This trend, however, has seen a reversal in the past two years due to mounting inflation concerns, bringing back the old normal. This shift in market behavior has significant implications for investors, making it more challenging to navigate the market and protect their portfolios.

Inflation Worries Impact Stocks and Bonds

The Unexpected Connection

In the world of finance, we often see that bad news for the economy can paradoxically turn out to be good for stocks, and vice versa. This unusual dynamic is once again in play, driven primarily by concerns about inflation. The recent weak job opening figures, which showed over half a million fewer vacancies than expected and the number of job quits reverting to pre-Covid levels, were taken as signals of a slowing economy. However, instead of causing panic, this news was welcomed by investors. The reasoning? A slowdown means less pressure on the Federal Reserve to raise interest rates, causing bond yields to drop and stock prices to rise.

Reverting to the Old Normal

This interesting market reaction could be indicative of a generational shift in market operations. Historically, aside from during major events like the Great Depression, World War II, and the Vietnam War, stocks and bond yields typically moved in opposite directions. This pattern shifted from 2000 to 2021, where investors grew accustomed to stocks and bond yields moving together, a trend that’s starting to revert back to the old normal due to inflation concerns. In fact, July saw a 14-day streak of the S&P 500 and 10-year Treasury yields moving in opposite directions, the longest such period since 2009.

The New Investor Challenge

In a stronger economy, there are two conflicting outcomes: higher profits (good for share prices) and increased inflationary pressure leading to higher interest rates (bad for share prices). Right now, investors are more focused on inflationary pressure. This new pattern poses a challenge for investors. Treasury bonds offer less protection in a portfolio, as their prices tend to move with stock prices. If stocks fall, so do bond prices, potentially leading to negative portfolio performance. This is a change from the previous scenario where Treasury prices helped to smooth a portfolio, moving in the opposite direction to stocks on a day-to-day basis while still generating long-term profits.

The Future of Stocks and Bonds

The question for investors is whether this negative link between stocks and bond yields will persist. Given the inflationary pressures due to deglobalization, industrial policy changes, corporate shifts from efficiency to resilience, and increased spending on defense and clean energy, it seems that investors will continue to focus on inflation. This focus could lead to a preference for slower economic growth, which would result in lower bond yields and higher stock prices. This situation creates a tension, as the economy has been surprisingly robust recently, raising growth expectations.

Final Thoughts

In the long run, those without a strong view on inflation should anticipate more volatility in their portfolios, as bonds no longer cushion daily stock-price moves. This increased risk makes leveraging less attractive. However, for those investing passively in stocks and bonds for the long term, the best advice remains the same: avoid checking portfolio value except when rebalancing. The current market setup might be challenging, but it also presents unique opportunities for those who understand the complex dynamics between inflation, stocks, and bonds.