Markets losing confidence in 'expert' ability to end inflation
The reason that the Bible emphasizes currency which is based on some fixed unit of measurement is that it is realistic about human nature. Shekels, Bekas, Talents, these are units of weight. The Bible even went to the trouble of defining the shekel in terms of a fixed weight and have it safeguarded by the Temple (and is called the Temple Shekel for that reason).
But debasing of coinage is a universal temptation for rulers, because it increases their spending power at the expense of everyone else. That's why debasement is condemned by the Torah, by Prophet Amos, the Prophet Isaiah, and eventually by the Protestant reformers (Let’s call inflation what it really is). For those who are reading the Gospels in a historical context, they see that the Ultimate Prophet, Jesus Himself, condemns the manipulation of the value of money by government for its own gain (This economic trend is an abomination.).
But the cult of expertise caused our rulers to set aside money which is fixed in value and embrace monetary authorities who would depend on academic credentialing for the common good. Fed critic Jim Grant says that we went from the "Gold standard" to the "Ph.D. Standard." But the biblical view of human nature holds that corrupted human will, not lack of expertise, is the chief problem with mankind. This is evident in almost all aspects of society today, and has led to a series of failures and loss of confidence by the people. For example, in public health authorities, and in defense and diplomacy authorities, and in media.
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This is also true in the realm of economics, and is especially centered in legitimate public doubt about the government's inability (or unwillingness) to prevent inflation. This shows up in polling repeatedly, but the poll which I watch most carefully is the minute-by-minute poll of people with the most skin in the game: investors. Investors have been increasingly signaling a belief that the Fed will quit the hard job of establishing price stability before the job is done. That pattern was clear last week.
Big Picture: Most economic and financial news last week lent support to the ongoing recent market trends signaling that the Fed will switch from its inflation fighting mandate to its recession fighting mandate sooner than expected. The Fed has two mandates, which complicates things quite a bit. What complicates them even more is that the mandates are contradictory. One mandate says the Fed should fight against unemployment by using inflation.
The idea is that inflation punishes savers, so the savers become spenders and spending grows the economy, putting people back to work. For those interested in the academic discussion, Google "Phillips Curve" or "NAIRU" (Non-accelerating inflation rate of unemployment). And the Fed focused on that mandate almost exclusively from 2007 until the last year. The other mandate is for the Fed to fight inflation by raising unemployment.
Of course, fighting inflation by raising unemployment conflicts with fighting unemployment by raising inflation. So the Fed switches back and forth between the two mandates, and markets swing up and down as the Fed swings back and forth.
Around the beginning of this quarter, markets began to sense that the Fed was softening in its resolve to fight inflation. Last week continued that trend. It started with remarks from the Fed Chairman who indicated the Fed would be doing less hiking than had previously been expected. Investors already knew the Fed had developed a dovish faction; what they hadn't known was whether the Chairman would try to appease that faction. As of last Monday, it looked like he was. In addition, a few surveys of business managers showed sentiment from that group at recessionary levels.
Remember, the Fed is supposed to fight recessions, so if the economy is that bad-off, it adds weight to the theory that the Fed would have to pivot away from tight money. In addition, it was announced that Austan Goldsby would be appointed to the Chicago Fed. I've debated Goldsby on CNBC and it is perfectly clear he is more on the Keynesian, dovish side of the spectrum. In addition, Chicago is heavily dependent on the commodities market, which benefits from inflation.
So, markets interpreted the news of the week as indicating that the Fed would risk continued inflation in order to try to avoid a recession.
We know the dove flight pattern well by now:
- Predicted Fed hikes implied by the futures markets fall.
- Gold rises.
- The dollar falls.
- Stock markets rise.
- Bond markets rise.
- Real estate markets rise.
- Inflation hedges outpace similar investments.
And that's what happened last week.
Something else interesting occurred. There are two metrics that use the futures market to predict Fed activity. One is called the WIRP report and is based on one particular model of using options to predict future rates. But there is another model, created by the CME (Chicago Mercantile Exchange), that focuses not so much on what the future rate will be, but rather on how probable that outcome is. The WIRP tells us what the market expects the rate to be.
The CME tells us how probable that outcome is and also how probable it is that a higher or lower rate will result. The WIRP showed a lower expected rate for all meetings over the next year, which means fewer or smaller hikes. The CME report showed that the probabilities had shifted such that if the predicted rates turned out to be wrong, they were more likely to be wrong to the upside. In other words, if we don't get the expected hikes, we'll get smaller rather than larger ones. In our view, that amounts to two big data points in favor of a dovish trade.
Sometimes a shift in expectations about future Fed policy also creates a shift in expectations about future growth prospects. In other words, often if there is a shift towards belief the Fed is going to be tighter, that shift is accompanied by anti-growth trades. This occurs because investors think the tightening of monetary policy might cause the economy to slow down. Or, conversely, if investors think the Fed is going to pursue easier money policies, they often go on to conclude that this will stimulate growth, because it will provide more credit to business and consumers. And in that case, pro-growth trades are the result. But it's important to remember that the Fed policy question and the future growth question are not necessarily the same thing.
Yes, usually high growth trades coincide with dovish Fed trade, but there are times when that is not the case, and last week was one of those times. Last week clearly signaled easier money policies but the growth signal was much less clear.
There were some pro-growth trades between broad asset classes last week:
- Stocks were positive.
- Stocks outperformed Real Estate.
- Industrial commodities performed well.
There were also anti-growth trades between broad asset classes last week:
- Bonds outperformed stocks.
- The yield curve got a little more inverted, which can be a sign of tightening credit.
So, last week fit the dovish pattern very well when it comes to comparative returns between asset classes (stocks vs. bonds vs. commodities vs. real estate vs. currencies), but the growth signal was mixed.
As we shall see in the detail below, the dovish pattern also appeared in the comparative returns within asset classes (e.g. one sector of stocks vs. another; one class of bonds vs. another, etc.). The growth picture was also mixed at that level of data: variations between sectors sent very mixed signals about growth. That suggests that investors think the Fed is going to take its foot off the brake pedal, but is not confident it will do so in time to avoid a crash.
This week we get a lot of new data. Especially important is a raft of inflation data. As of this writing, the ISM Service Index has already been released, was worse than expected and reversed last week's trades, because that's how quickly a single number can flip expectations between the dual (or is it duel?) mandates.
Bond Markets Last Week: Stocks mildly underperformed bonds, which constitutes an anti-growth signal, albeit a weak one. In addition, variations within the various types of bonds were generally sending pro-growth signals.
Bond markets were generally up last week, which fits the narrative of an easier Fed. After all, if the Fed is going to be buying more bonds (or at the very least selling fewer bonds), it's no surprise for bond investors to see that as good news for that asset class. But the macro-economic picture is magnified by taking a higher resolution look at the data, turning the magnification level up to see how different types of bonds reacted.
Treasury bonds, the ultimate safety play, underperformed high-credit-quality corporate bonds, which are considered a little riskier. The premise is simple: when business slows down, companies find it harder to make their debt payments, but the government can always tax or print more. So, corporate 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, markets acted as though growth will be high enough for well-financed corporations to make those payments. That's called 'risk on'.
However, it was not a strong 'risk on' environment - low-credit-quality corporate bonds lagged high credit quality ones. Riskier bonds pay higher interest in order to compensate for that risk. So, if investors get a lot more optimistic they focus more on that higher interest and less on the risk of default. These bonds are usually called "high yield" (for obvious reasons), but during tough times the old nickname "junk bonds" also appears. Last week, investors reached somewhat towards more risk (corporates), but moved away from very risk-taking territory ("junk bonds"). That's another mixed, but leaning pro-growth, signal.
Switching from the growth to the inflation topic, inflation-protected securities performed well compared to their non-inflation protected alternatives. That implies more fear of inflation. Because if investors buy inflation hedges, it is logical to consider it likely they are more worried about inflation. That also fits the dove trade: if the Fed stops fighting inflation, we'll probably get more inflation.
Real Estate Markets Last Week: REITS performed positively, but generally lagged most stocks and most bonds. This is not exactly what one would expect given the prevailing themes of the week: falling rate expectations, rising inflation risks and (maybe) and possible acceleration in 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 two of those pro-REIT conditions were more likely to occur than previously thought and the third (growth) was unclear. So 2½ out of 3 pro-REIT factors were expected to improve.
U.S. Stock Markets Last Week: Domestic equity markets were generally up last week, but not equally so. Growth stocks beat value stocks across size categories.
Growth tends to beat value when growth expectations are rising, because low growth presumably makes it harder for earnings to actually deliver on growth companies' high expectations. So, the strong growth performance is consistent with pro-growth trades. So maybe growth outperformed because of rising growth expectations. But that is indeed a maybe, because the pattern last week was mixed in terms of the growth signal.
On the other hand, the strong performance of growth stocks might have been driven by falling interest rates. Growth stocks are more dependent on low interest rates than value stocks, so consequently, they also tend to overperform value stocks when interest rate expectations are falling, because their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings. Whatever the discount rate is, it tends to have a larger effect when it is applied over a more years of discounting. The value-expanding effect of low rates helps companies whose investment premise is based on the long view more than those whose investment premise is based on the short view. Since last week was about a shift towards lower rate expectations, it's no surprise that growth beat value. That's what basic theory and history would expect.
It's honestly hard to know how much last week's growth vs. value performance was about the Fed taking it's foot off the brake pedal and avoiding a recession.
That ambiguity is not cleared up by looking at the difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, and discretionary/utilities. Those various comparative returns were pretty evenly split between pro-growth and anti-growth trades.
Bottom line: Last week markets sent a clear message about an easier Fed, but not a clear message about the severity of a possible recession in the near future.
International Stock Markets Last Week: International equity markets were generally up for the week. In general, U.S. lagged global stock markets in price returns. This occurred partly because of a falling dollar. In other words, foreign markets generally performed better than U.S. markets and part of the reason for that was the fact that their currencies generally performed better than the dollar. That fits with the dovish trade which weakens the dollar, and it also fits with the idea that markets are continuing to back-off from the expectation that the U.S. will be 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 the last couple of weeks, markets have been less confident that we could avoid the global crash.
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.”
