Good news is bad news: Why economic strength has the market’s attention

For much of the year, the capital markets have been in a tug of war between opposing forces. High, although falling, inflation versus slowing growth. The increasing possibility of an economic soft landing versus the real risk of recession. A contraction in corporate earnings versus the enthusiasm around the potential of artificial intelligence (AI). Strong returns for a handful of large-cap tech names tied to that AI opportunity versus flat or negative returns for most stocks in the S&P 500.

Against that backdrop, all eyes have been on the Fed, which has continued to ratchet its short-term policy rate higher in response to the dual risk of heightened inflation and an exceptionally tight labor market. The persistence and magnitude of those rate increases have blown well past even pessimistic estimates from early 2022, lifting short-term interest rates to a range not seen in over two decades. Coming out of their last policy meeting on September 20, policymakers updated their forecast, hinting strongly that they may not be done with their hiking cycle. Moreover, the Fed continues to reaffirm its “higher for longer” stance — a clear message that it doesn’t expect to reverse course and cut rates in the near term.

The unexpectedly strong report on job openings earlier this week only served to reinforce that potential — a message that wasn’t lost on investors. Major stock indexes have been edging lower in recent weeks but volatility has picked up in recent days. The VIX index, a commonly used gauge of stock market volatility, surged yesterday to its highest level since May. Even so, the S&P 500’s decline has been relatively contained — now down by about 7.5% from its 52-week high. The index has benefited from the outstanding performance of a handful of tech-oriented names tied to AI, which has masked relatively weak returns across other sectors and down the capitalization spectrum. Small caps, measured by the Russell 2000, have declined by nearly 14% from their one-year peak.

Looking past stocks, the more notable development has been in the fixed income market, where long bond yields have risen sharply over the past month. The yield on the 10-year Treasury touched 4.8% this week — up 0.5% in just a month — to reach its highest point since 2007.

Arguably, it’s been the sharp increase in long-term yields that have been the primary catalyst for the surge in equity market volatility in recent weeks, driven by data suggesting that the economy has maintained a surprising degree of momentum despite the significant tightening that has occurred. That’s raised renewed concerns about the near-term inflation outlook, the potential for the Fed to raise rates even further, and the potential for that additional tightening to choke off growth.

The bottom line? The strong jobs data was a classic “good news is bad news” scenario for the markets.

What’s next?

Although the AI story that emerged this year was a powerful catalyst for a handful of stocks, macro considerations have been the primary driver of both fixed income and equity markets this year, largely focused on the economy and the Fed. The tug of war between conflicting forces hasn’t been resolved. More recently, the focus has returned to the convergence of potential risks that could make a soft landing difficult.

Of particular note are the risks created by a prolonged UAW strike, rising energy costs, the resumption of student loan payments, and — until recently — the potential for an imminent government shutdown. Individually, none would appear to be sufficient to cause the economy to stall. The collective weight of multiple small shocks to an economy already feeling the effects of higher interest rates does increase that potential.

With the Fed now signaling a growing likelihood of another quarter-point rate hike before year-end to try to soften up tight labor markets and rein in inflation, the path to a soft landing will also narrow. The determining factor will likely come down to consumers — specifically, their ability and willingness to continue to increase spending.

That could prove challenging as the three primary tailwinds that have supported spending fade. Wage growth has been slowly declining as labor conditions have cooled. The massive stockpile of cash accumulated since 2020 has been significantly eroded. Consumer credit outstanding has increased sharply in the past year and now surpasses its pre-pandemic peak. As the sources of fuel for household spending continue to dwindle, consumption growth will be difficult to maintain.

Just as they have over time, consumers have proven to be resilient in the face of uncertainty. Real consumption growth, which is the largest driver of the U.S. economy and feeds directly into GDP, has benefited from falling inflation. How long will that continue? There’s no way to say definitively. As we look ahead from here, it’s certainly possible that the economy could continue to expand for some time.

Boil it all down

Given the ongoing push and pull on the market from these conflicting forces, investors should be prepared for the possibility that volatility could continue in the near term. During periods of uncertainty, the importance of maintaining a long-term perspective is critical. The benefit of having an investment policy is seldom more obvious than when the extremes of fear and greed emerge. While market conditions are far from extreme, this environment presents a good opportunity for investors to reaffirm their goals, objectives, and needs.

Maintaining adequate liquidity reserves is an important starting point. With money market yields as high as they are, the opportunity cost for holding cash may not feel as significant. Investors should hold enough cash to address foreseeable needs and provide a sense of security should market volatility intensify.

While some have questioned the value of bonds given high cash yields, we believe that the investment case for bonds is increasingly attractive. Cash yields can easily reverse course — and will if the economy slides into recession and the Fed is forced to slash rates. Over multiple cycles, we’ve seen core bonds outperform cash once the Fed stops tightening. Although it’s possible that long-term rates could rise further, the ability to lock in yields not seen in over a decade should be attractive for long-term investors.

With forward-looking bond returns considerably higher than they’ve been in many years, it’s an opportune time for investors to evaluate their investment policy. Bonds have always been an effective portfolio diversifier. The transition to a higher rate environment has been challenging, but bonds are well positioned to contribute meaningfully to forward-looking portfolio returns. As a result, investors may be able to reduce their exposure to stocks and other risk assets while maintaining a comparable or better long-term return target, judiciously reducing portfolio risk without sacrificing their ability to meet their long-term objectives.

We’ll continue to monitor developments, seeking opportunities that may emerge to adjust portfolio positioning as appropriate. We’d invite you to participate in our upcoming Investor Insights webinar on October 17, where we’ll be discussing in greater detail the current outlook for the economy, policy, and the capital markets. If you’re interested, you can register to participate on our Investor Insights page.