Why a strong US economy prevents stock investors from flourishing

  • The “good economic news is bad news” story continues to dominate the stock market.
  • The recent rally in equities is collapsing as inflation data shows the Fed still has a lot of work to do.
  • But the data also shows that the economy is strong, and this could help the US avoid a recession.

The US economy has been receiving a lot of good news lately, from a strong labor market to high consumer spending.

But investors do not welcome a strong economy. In fact, markets are behaving as if they want the opposite: stocks are mired in a deep sell-off as upbeat data points to more aggressive action by the Federal Reserve.

Of course, inflation remains high, as evidenced by personal consumption expenditure data released on Friday, which showed prices rose more than expected in January. But it is also part of the mystery of the market and the economy.

After a dismal 2022 for the S&P 500, which lost 20% last year, the stock market soared in the first six weeks of the year as traders bet that inflation was declining and the Fed would be less aggressive in its policies.

However, the rally has slowed in the past two weeks as inflation concerns rear their heads again. On Friday, PCE data for January came in hotter than expected, sending stocks down to a second consecutive week of losses. This follows data earlier this month that showed the US economy is resilient in the face of higher interest rates.

The good economic news has taken a toll on the market as it suggests the Fed will continue to tighten the screws on monetary policy, hurting corporate earnings growth and stock prices. And given the severity of inflation in January, a longer-term hike in interest rates looks more and more likely.

The market often operates in one of two modes. It is either related to the economy and rises or falls according to the data, or it is not connected, as it is now, jumping on negative events and falling when there is good news. Investors have been in the latter mode for about a year now.

But here’s the catch: While a booming economy portends more Fed belligerence, that strength could save the US from a major recession.

Gap between markets and economy

Two recent data stand out when looking for answers about the state of the US economy. First, the Monstrous Jobs Report for January. Employers added 517,000 jobs last month, bringing the unemployment rate to a 53-year low of 3.6%.

Second, consumer health, reflected in retail sales and consumer spending data for January, which beat estimates.

Resurgent inflation is indeed the Fed’s worst nightmare, but the data also begs the question: Is a recession really around the corner, given the strength of the consumer and labor markets?

Either way, the stock market doesn’t seem to care. All investors can see are higher rates, which do a double whammy, swallowing up corporate earnings and making other investments more attractive than relatively high-risk stocks.

“This morning’s data suggests the economy is very resilient and could encourage more betting that the Fed will have to push rates closer to 6.00%,” Oanda’s Ed Moya wrote in a note following the release of the January PCE data.

Meanwhile, Nationwide head of economic research Mark Hackett wrote in a note that the chances of a recession are waning even as inflation remains high and further rate hikes are likely.

“The chance of a recession is still high, although Bloomberg’s recession chance forecast has dropped this week in just the second week of May 2021 to 60% over the next year. The Citigroup Economic Surprise Index rose to its best level since last April, gaining 60 points since mid-January, with data measuring current activity remaining strong,” Hackett wrote.

Not so long ago, the Bloomberg model predicted a 100 percent chance of a recession.

Even an inverted yield curve, the most reliable indicator of a recession in history, hasn’t dampened the enthusiasm. This is because there is another pocket of resilience compared to previous economic downturns. As Ned Davis Research put it:

“In the regime of sufficient reserves, in which we were after[financial crisis], banks also have a lot of deposits. They do not need to borrow from the federal funds market to meet reserve requirements. As a result, inverted curves are less effective in conveying financial conditions to the real economy.”

This month, economist Jeremy Siegel also reaffirmed his view that the Fed does not need to fuel an economic downturn to fight inflation and urged investors to stop “hysteria” over inflation news.

Siegel has long been of the opinion that inflation is in fact inflated in official statistics, given the delay between rate hikes and when their effects show up in the real economy.

Thus, there is strength at the heart of the economy, even as traders brace for the worst and the Fed prepares for a longer fight against high prices.

And, ultimately, the Fed will have the final say on stocks, even if the economy survives its aggressive policies.

The only thing Jerome Powell sees when the U.S. gets a job-surge report or when consumer spending rises is hot inflation, and that will determine the moves of both the central bank and the market this year.

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