Understanding the times using financial markets
Every hour of every day investors are making observations about what they see in the economy. That's billions of eyes and ears seeing and hearing things which no expert can pretend to see and hear. And then they make decisions based on what they see and their actions reflect their knowledge. That seems to be how the "Sons of Issachar…understood the times". I make the case here that Issachar was a scribal class engaged in Torah study, and also as a clerical class who would have done record keeping for Zebulon, the commercial class (Rethinking Wealth 6: Jerry Bowyer). As such they would have seen the effects of debtors leaving to join the camp of David in default rates and possibly in interest rates. That still applies today: all of us know more than some of us.
That principle still applies. The combination of Issachar's Biblical framework for interpreting the commercial and financial data from the Zebulon, the trading tribe, led to an understanding of the times. This is also an application of the principle of Solomon who said "In a multitude of counselors there is safety." There is no process with incorporates a larger multitude of counselors than the marketplace. Every buyer, seller, borrower and lender on the planet is by their actions registering their knowledge, their counsel, whenever they engage in a transaction. Markets bring billions of counselors together, and in addition, it gives higher weight to those who have more successfully understood the economic times than those who did not, because more successful investors have more assets and therefore move markets more.
Let's look at what the multitude of counselors said last week.
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Big Picture: Last week's investor behavior seemed largely to be driven by two new economic reports: third quarter GDP and personal spending report for September. Both of them were interpreted by investors as likely to cause the Fed to hike rates less and reverse the hiking trend sooner. The GDP numbers were a bit higher than expected; the details were such as to imply that the expansion was not good news. Growth was below the long-ter average, despite coming out of a two-month recession. The growth was driven by components of the economy that do not tend to remain elevated, such as a slight surge in exports. As we have seen many times, however, disappointing economic news is often good news for investors, because economic news is read through the filter of how it will affect the world's largest investor, the Fed. When the economy looks too weak, investors often conclude that the Fed will create new monetary base and use it to invest in markets. This drives up the price of assets (because it's buying them) but also increases the risk of inflation (because it's buying assets with newly created money). That's consistent with what happened last week.
Furthermore, both the GDP and Personal Expenditures reports have inflation components, and both were lower than expected. That gave further impetus to the thesis that Fed would lighten up. The slowing growth was interpreted as showing that the economy is not strong enough to stand much inflation-fighting chemotherapy and the lower-than-expected inflation numbers associated with GDP and personal income were interpreted to indicate that there is not as much inflation to be fought as previously thought. Those two things pulled investor consensus towards a more dovish outlook.
The investor reactions were straight out of the 'kinder gentler ed' trade playbook.
- Gold rose.
- Bitcoin rose.
- The dollar fell.
- Futures markets signaled smaller Fed hikes in the future.
- Futures markets indicated that the Fed would start cutting sooner.
- Bond yields generally fell.
- Most stock markets rallied, outpacing most bonds.
- Inflation-hedged bonds rallied.
- Commodity indices generally rose.
In other words, with the exception of some bond yields, we saw a "Fed on" trade. Markets acted as though the Fed would leave more monetary stimulus in place than had previously been thought.
In addition, when looking at general asset classes (stocks vs. bonds vs. commodities), it was a mixed "risk on" trade in terms of growth. The S&P outperformed Barclay's Agg (a growth trade) but some other stock indices underperformed bond indices (an anti-growth trade). So the stock vs. bond picture did not clearly point one way or the other regarding growth. Furthermore, energy rose (a pro-growth trade), whereas copper fell (an anti-growth trade). Remember, even the "growth" trades really mean "less downturn" trades): markets have seemed to rule out a genuine upturn: the debate has been about how bad the slowdown will be.
Last week was an "inflation on" trade for the most part. Currencies, cryptos, and inflation-hedged bonds followed that pattern.
Also, the markets shifted against the US, meaning they broke from a pattern of US overperformance to US underperformance. In other words, markets acted as though they had already more than priced in bad global news.
These comparative returns between asset classes such as stocks, bonds, currencies and commodities are consistent with the following account: the Fed is losing its nerve and will be less aggressive in fighting inflation and therefore less successful in avoiding it. The upside is that it is not clear that it will crash the economy.
This coming week there will be a wide range of data releases, but the big item is likely to be the Fed meeting and the policy which is announced at that meeting. Markets have priced in a 0.75 interest rate increase, but smaller increases after that and actual cuts next Summer.
Real Estate: REITS performed quite well, which one would expect given the prevailing themes of the week: falling rates, rising inflation risks and possible improving 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 they were given two of those things with clarity and some encouraging signs about the third. REITs performance is typically between that of equity markets and bond markets, but last week REITs outperformed both. That's likely due to the clarity about inflation and interest rates.
U.S. Stock Markets: Domestic equity markets were generally up last week, with growth stocks significantly underperforming value stocks. That underperformance occurred among the large, mid and small size company categories. Growth tends to lag value when growth expectations are dropping. Growth stocks tend to lead value stocks during times of rising economic growth expectations, because growth presumably helps earnings actually deliver on growth companies' high expectations. So, the lagging growth performance could signal an anti-growth trade.
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. Since last week the consensus of markets we've looked at signal lower interest rates than previously expected (which should be good for growth stocks) and the growth picture was not at all clear, then it's hard to find a clear explanation for growth lagging value. One possible explanation is the switch away from preference for the US. We've seen that often in the past, as the US was seen as a haven, we saw not just a shift towards US markets, but also within the US markets, a shift towards growth trades. If markets have reached doubts about the US as a haven, they might also be moving away from the high risk/high return sectors and styles.
The difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, discretionary/utilities, etc., showed a more pessimistic growth shift.
So, the lower future rate picture was fairly clear in the data, but the softer landing picture was far from clear.
Global Stock Markets: International equity markets were generally up for the week, more so than U.S. domestic equity markets. This was due partly to a falling dollar. In other words, foreign markets generally performed better than U.S. markets both because those markets rose, but also because of currency effects. This all suggests that markets are doubting the recent theme that the rest of the world will have a harder landing than the US.
In addition, EM underperformed DM significantly. EM currencies were up against the dollar, roughly at the same rate as developed market currencies. That underperformance tips the scale a small bit towards a global anti-growth trade.
Last week international markets returns were driven largely by level of development, and not by region.
Bond Markets: Bond markets were generally (but not universally) up last week, which fits the narrative of the week - the Fed will sell fewer bonds.
But the real story is found by comparing different types of bonds, at individual sectors. The story was consistent with the softer landing, with high yield bonds and investment-grade corporate bonds significantly overperforming treasuries.
The growth thesis is simple: when business speeds up, companies find it easier to make their debt payments. So lower-credit-quality bonds are less likely to default and forward-looking investors buy them now.
On the inflation side, inflation can help over-leveraged businesses, which will pay back loans in dollars that are worth less than the ones the company borrowed, so the surge in corporate bonds might reflect an inflation tailwind. TIPS performed roughly on par with non-inflation-protected treasuries.
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.”
