Markets Rebound as Good News Returns

In the past few weeks, investors have started to pay less attention to inflation and more to the state of the economy. This shift is good news for stocks, which tend to do better when the economy is doing well.

This is a big change from the rally that lifted the S&P 500 from just after Christmas until mid-January. During that time, bond yields fell as inflation fears receded. Since then, however, stocks have switched from rising when bond yields fall to rising when bond yields rise—a return to what counted as normal for most of this century.

In other words, economic growth is good for businesses because it means higher profits. However, this growth may not last, as there are several factors that could lead to inflation. This is bad news for investors who are hoping to return to business as usual.

The recent close relationship between stock prices and bond yields is unusual, with the two moving in the same direction on all but one day in the past 10 trading days. This tight link is the strongest seen since the brief recession panic in May 2022. The correlation between the two, a mathematical measure of how closely they are in sync, has jumped to 80% after being negative for most of last year. (On Monday, they moved in opposite directions again, though early on Tuesday stock futures and bond yields were falling together.)

This pattern of stocks and bond yields moving in opposite directions held for most of this century, until breaking decisively last year. This made life much easier for investors, as it dampened volatility while still allowing them to make money. The standard 60% stock, 40% bond portfolio smoothed returns, as stock and bond prices tended to cancel each other out on a day-to-day basis. However, last year this approach was crushed, as prices moved together—that is, stocks fell when bond yields rose, and vice versa. As a result, both stocks and bonds fell heavily over the year. It would be great if the old pattern was back.

There are clear justifications for stocks to be higher and bond yields lower than a few months ago, as inflation has come down, China has reopened and Europe’s mild winter has eliminated fears of energy shortages. However, it is possible that this is simply wishful thinking.

The recent shift in the stock-bond link requires a belief that inflation has been vanquished. However, the market is well ahead of the economic evidence, and it is easy to see how the new regime could be upset.

The first test for the Federal Reserve comes on Wednesday, when the central bank is widely expected to raise interest rates by 0.25 percentage point. This would be the first rate hike of the year, and would come after a series of 0.5-point hikes in past years. The key question will be the tone of Chairman Jerome Powell’s press conference. Will he nod to the idea that inflation pressures are abating?

The biggest doubt surrounds wages, which is the main concern of the Federal Reserve when it comes to self-sustaining inflation. Although wage growth has moderated and job openings have fallen, this supports the argument that there is less to fear. However, unemployment remains at 50-year lows, there are still 4 million more jobs on offer than there are unemployed workers, and while wages are rising more slowly than they were, they are still rising too fast for the Fed's comfort. In addition, they are rising faster than the Fed's preferred measure of inflation, which could eat into corporate profit margins.

The recent good news for the world economy, with the International Monetary Fund upgrading its growth forecasts, is affected by China's reopening. This positive development comes on top of other positive news for the world economy.

A stronger economy is generally good for stocks, but if it leads to more inflation, that could be a problem. For now, investors believe that any extra inflationary pressure will be manageable. That's why stocks that are sensitive to the economy (cyclical stocks) have been doing better than defensive stocks since late December.

It's possible that we'll see inflation-free growth, but it's more likely that inflation fears will return in the near future. This would mean that stock prices and bond yields would start moving in opposite directions again.