Why markets are swinging so much on economic news

The original version of this article first appeared in The Business Times.

It is the top preoccupation of 2022 where the financial markets are concerned: watching the Fed.

To add to the fanfare, the key speech delivered by Federal Reserve chairman Jerome Powell on 26 Aug 2022 was live-streamed for the first time since the beginnings of the Jackson Hole symposium, a key annual gathering of central bankers. It was a nod to Powell’s commitment to communicating directly with ordinary Americans.

In his first paragraph alone, he promised remarks that would be “shorter, my focus narrower, and my message more direct” than past speeches he had made at the closely watched event. To restore price stability, it will take some time and the Fed using its tools “forcefully” to bring demand and supply into better balance. That means that the Fed will not, as some in the market had expected, lighten up on its rate hikes.

Call it sport or spectacle, but the 8-minute speech pushed the S&P 500 down by more than 5% in the three trading days after the speech was delivered. Nasdaq fell close to 7% over the same period. By Bloomberg’s estimates, the market tumble wiped out US$78 billion from America’s richest people.

Why are the stock markets so jumpy? The 46 times that Powell utters the word “inflation” is the whodunnit clue flashing in neon lights. The aim of the speech was to simply state that the Fed is single-mindedly focused on controlling inflation. To bring inflation down will likely require a sustained period of below-trend growth, softer labour market conditions, and consequently, some pain to households and businesses.

After a decent bounce in markets across the summer, the pointed comments have set off a new cycle of bearish takes that was prevalent in the earlier months of this year. Market sentiment is swinging through extremes — being highly reactive to the words and actions of the Fed — as it switches from bearishness to bullishness and back to bearishness again.

There is a circular argument going on here — we went through it and we are now back at the top again. It goes something like this:

• Powell and the Fed are serious about fighting inflation and they will tighten for as long and as much as necessary to tackle and bring down inflation. That is bad for markets.
• This means that the risk of recession is rising and that will cause demand to drop, hurting the economy and earnings. That is really bad for markets.
• Weaker market and economic data will mean the Fed will not have to worry about inflation anymore and can stop raising earlier, and even possibly start cutting rates. That’s really good for markets.

We just rotated from point three to point one, and with every new Fed comment and economic data, we will keep going round and round again.

One major fallout from the recent move higher in market interest rates is the performance of global bonds, which have now officially entered its first bear market in decades.

Specifically, the Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds has fallen by more than 20% from its 2021 peak on an unhedged basis — the most since the index’s 1990 beginnings.

Such headlines may stir some panicked responses at first glance. But what’s interesting to see is that in fact, the bond markets reacted in a rather muted fashion to Powell’s Jackson Hole speech as compared with the equities markets.

The nub of the current conundrum is in timing, and that comes from having a few key questions about the world’s largest economy answered: When will inflation peak? When will growth turn negative? When will the Fed cut rates?

By definition, fixed-income investors are top-down investors who focus on tracking macroeconomic data such as inflation, interest rates and monthly economic data. Equities or stock investors are bottom-up investors who zoom in on microeconomics or individual companies’ performance.

Despite the big looming questions about the US economy, the latest market movements tell us that the bond markets have already priced in a certain future expectation, with Treasury yields well above 3.5% — depending on the maturity — compared to the Fed, which is still at about 2.5% and playing catch up.

With rising interest rates, the bond market takes a negative hit, but there may yet be opportunities for investors in the space. The repricing of bonds, once the price impact is over, will allow investors to take advantage of the higher interest rates to reinvest into higher-quality bonds with the same or better yields. As long as the weaker economy doesn’t damage credit quality, and we do not see a major increase in defaults, which doesn’t seem likely at the moment, the normalisation of the bond market may be nearer.

Meanwhile, the heightened volatility in equity markets suggests that investors are focused on the intentions of the Fed, and taking bets on the central bank’s future behaviour. The uncertainty has left investors looking for quality and dividend stocks that are likely to demonstrate defensive qualities. Since these companies are expected to have strong balance sheets, they can both weather weakness in economic growth and be sheltered from higher borrowing costs.

All that said, the market has already told us where the Fed is likely to be headed and the Fed is quite transparent through their dot plots and guidance. So the variability of outcomes is likely to be narrow. Does it peak at 3.5% or 4%, and does the Fed rate peak in Q1 or Q2 next year? The outcome is unlikely to be a major surprise. While financial geeks may have found a new sport from watching the Fed tighten rates amid high inflation after more than a decade of quantitative easing, it may end up being as exciting as watching paint dry.

The trillion-dollar global bond market remains efficient at pricing in future expectations pretty quickly. Bottom-up investors meanwhile will keep trying to forecast macroeconomic directions and to rework their models to find the right target prices for stocks in these times. But most often they too are chasing the market down, and they will likely miss the bottom and chase the market back up again. When markets are volatile, it normally means that there is no consensus and if there is, then the consensus is likely to be wrong. There has never been a consistent way to predict the future direction of markets.

So instead of fretting over every word from the Fed chair or the minutiae of market volatility, investors can — and should — focus on the long-term macroeconomic trends and long-term secular market returns, and to cut through the noise of the current cycle.

Be clear about your specific financial priorities and goals, depending on your current life stage. Then commit to securing returns for the years ahead by adding to your investments in a consistent and patient manner.

Instead of trying to solve the macro conundrum by timing the market, let efficient markets solve it for you through time. The aim of investing is not for us to react to volatility, but to find peace of mind in spite of it.

Read more: Adjusting to a new era of higher prices

It's never too late to start investing and it's never too hard to find a team of experts who are aligned with your interests. Open an account in less than 10 minutes and start your investment on Endowus.

<divider><divider>

Risk Warnings

Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Rates of exchange may cause the value of investments to go up or down.  

This article is not intended to be relied upon as a forecast or research or investment advice, and should not form the basis of any investment or other decisions. The information contained herein is not intended, and should not be construed, as any legal, tax, regulatory, accounting or financial advice. If you would like investment, accounting, tax or legal advice, you should consult with your own professional advisors regarding your individual circumstances and needs.

The information in this article may not be suitable for all investors. You are responsible for any action that you take or decision that you make in reliance on any content in this article, and you agree that Endowus HK Limited (“Endowus”) is not liable under any circumstances.

No invitation or solicitation

Neither the information, nor any opinion, contained in this article constitutes a recommendation, offer or solicitation  by Endowus or its affiliates to you to buy or sell any securities, collective investment schemes or other financial instruments or services, nor shall any such security, collective investment scheme, or other financial instruments or services be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.

This is not intended to be an invitation or offer made to the public to subscribe for any financial product or to enter into any transaction.

Accuracy of Information

Whilst Endowus has made reasonable efforts to provide accurate and timely information, there may be inadvertent delays, omissions, technical or factual inaccuracies or errors in any such information.Endowus does not warrant or represent that the information in this article is correct, accurate or reliable.

Opinions

Any opinion or estimate above is made on a general basis and none of Endowus, nor any of its affiliates, representatives or agents have given any consideration to nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Opinions expressed herein are subject to change without notice.  

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this article are subject to market influences and contingent upon matters outside the control of Endowus and therefore may not be realised in the future.

In presenting the information above, none of Endowus, its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision.You should carefully consider whether any investment views and products/services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances.

This article has not been reviewed by the Securities and Futures Commission of Hong Kong.