In a fascinating twist of investor sentiment, the stock market has been reacting positively to the recent spate of "bad economic news", as traders interpret signs of an economic slowdown as a harbinger of continued low interest rates. The trend, which has been in place for nearly nine months now, is based on the assumption that softening economic data and lower inflation may prompt the Federal Reserve to pause its interest rate hikes, according to Chris Fasciano, portfolio manager at Commonwealth Financial Network.
However, this counterintuitive response to adverse economic indicators is not without its critics. Some analysts argue that a rolling recession is underway, with sector-by-sector economic downturns not yet translating into an overall decline. The possibility of a significant downturn in housing and labor markets, however, could change the narrative, warns Jamie Cox, managing partner at Harris Financial Group. Investors are also keeping a wary eye on inflation, with any signs of acceleration potentially signaling that bad news could indeed become bad news for the stock market.
Investors’ Reaction to Economic Data May Affect Stock Market
As the second-quarter earnings season ends, stock investors are keenly observing the latest economic data. Interestingly, they have been reacting positively to the so-called "bad economic news," or any data suggesting an economic slowdown. This trend, which began about nine months ago, is based on the presumption that softening economic data and lower inflation might lead the Federal Reserve to halt the interest rate hikes, explains Chris Fasciano, a portfolio manager at Commonwealth Financial Network.
Market Predictions and the Federal Reserve
Currently, traders in federal-funds futures are pricing in a more than 90% chance that the Fed will keep its policy interest rate unchanged at the September meeting. There is also a roughly 35% probability that the US central bank will increase interest rates by 25 basis points in November. This comes as the US stocks closed the week higher, following data that pointed to a cooling labor market. The US created 187,000 new jobs in August, with the unemployment rate rising to 3.8% from 3.5%.
Economic Slowdown or Recession?
While the data supports a narrative of a gradual slowdown in the labor market, there is no indication of significant weakening in the economy, affirms Richard Flax, chief investment officer at Moneyfarm. However, others like Jamie Cox, managing partner at Harris Financial Group, believe we are experiencing a "rolling recession," where recession activity moves from sector to sector without leading to a broad-based decline.
The Future of Stock Market
To disrupt the cycle where bad economic news is good news for stocks, economic data would have to indicate more damage from high-interest rates, says Flax. The trend could also reverse if there is a meaningful downgrade in corporate earnings expectations. Investors should also be mindful of the possibility of accelerated inflation, warns David Merrell, founder and managing member at TBH Advisors. If investors begin treating bad economic news as detrimental to the stock market, it could put pressure on the 2023 stock-market rally.
Week Ahead in the Market
In the coming week, investors will be anticipating data on the July US international trade deficit, the ISM services sector activity for August, weekly initial jobless benefit claims data, and the July wholesale inventories data. They will also be keen on the speeches of several Fed speakers for clues on whether the central bank is ready to stop hiking its rates.
The market’s reaction to economic data is fascinating, with some investors viewing "bad news" as a positive indicator for the stock market. However, it’s crucial to understand that this trend could reverse if there’s a significant downgrade in corporate earnings expectations or if inflation accelerates. Therefore, investors should remain vigilant and consider all economic indicators before making decisions.