Why good economic news is bad news for markets
It is one of the perversities of the current state of financial markets that good economic news is not necessarily good for investors.
The reaction of equity and bond markets overnight to a slew of positive economic data was rational.
Investors have been optimistic that with inflation rates in the US and the eurozone apparently subsiding, the end of the interest rate-hiking cycle is on the horizon, with only a couple of 25 basis point increases by the world’s most influential central bank, the Federal Reserve, to go before the cycle peaks and US rates start to fall late this year.
With markets pricing in a near-perfect outcome – the Fed finessing its monetary policy to orchestrate a soft landing for the US economy – it doesn’t take much, however, to unsettle them. Investors know that a market priced at about 18 times prospective earnings is vulnerable to any miscalculation of the Fed’s actions.
On Tuesday, a raft of purchasing managers indices – indices that track the trends in the manufacturing and services sectors – was released. Unfortunately for investors, they contained unexpectedly good news.
In the US, the S&P Global composite PMI rose from 46.8 in January to 50.2 in February, with the manufacturing index rising from 46.9 to 48.4, a four-month-high, and the services index from 46.8 to 50.5, an eight-month-high.
Anything below 50 says activity in the sector is shrinking. Anything above 50 says it is growing. While the manufacturing index says the sector is still contracting, it is doing so at a materially slower rate.
Unsurprisingly, US markets reacted badly to the news, with share prices falling across the board and bond yields rising.
The S&P 500 was down almost 2 per cent and the more tech-heavy (and higher-multiple of earnings valued) Nasdaq index slumped 2.5 per cent. Bitcoin, a good proxy for the extremes of risk appetites, was also about 2 per cent off its high for the day.
The yield on two-year US government notes spiked to a three-and-a-half month high of 4.74 per cent and that of the 10-year bond to 3.96 per cent, also its highest since early November. At the start of this month, the two-year notes yielded 4.11 per cent and the 10-year bonds 3.42 per cent.
The detail of the S&P Global survey would have discomfited investors as much as the headline numbers, with the rise in input costs slowing but output charges – selling prices – quickening as companies passed on their higher costs to customers. That was the case in both the manufacturing and the service sectors.
Globally, the supply chain bottlenecks that helped trigger the worst outbreak of inflation in four decades appear to have been largely resolved, hence the slowing rate of growth in input costs. The subsiding of energy prices, which had surged after Russia invaded Ukraine, is also easing the pressure on manufacturers.
Companies are, however, now putting up their prices for their customers and ultimately consumers, and that’s feeding into the core of the inflation rate and generating pressure for wage increases that would entrench high inflation rates unless the Fed acts more aggressively.
Where the market was pricing in two more 25 basis point increases in the federal funds rate (the US equivalent of our cash rate) previously, it now thinks there will be at least three more rate rises this year, and no relief until 2024.
Not so good surprises
The US isn’t the only economy where the data is surprising on the upside.
In the eurozone, the composite index rose from 50.3 in January to 52.3 in February and in the UK it went from 48.5 to 53. Prices in both jurisdictions are rising to cover wage increases even as, as is the case in the US, better functioning supply chains have slowed the rate of price increases for factory inputs.
It is the service sectors that are driving the recovery in activity. That’s good news for the economies – services are the larger part of most developed economies, accounting for nearly 80 per cent of the US economy, for instance — but strengthens the view that central banks will probably have to go harder for longer than previously anticipated.
A similar picture to the US and Europe was seen in Japan’s PMIs, with the au Jibon Bank’s flash services PMI rising from 52.3 to 53.6, but the manufacturing PMI falling from 48.9 to 47.4, its largest decline since August 2020 and the fourth consecutive month where the activity has contracted.
Japan’s inflation rate is rising, and its central bank is under intense and increasing pressure to abandon the unconventional monetary policies it has pursued, with some of those policies – designed to keep interest rates low and inject liquidity into the economy to avert deflation – in place for decades.
Mood changes
In Australia, where similar trends to those seen elsewhere have developed, yields have also been spiking this month. The yield on two-year government securities are up from just under 3 per cent in early February to 3.62 per cent and 10-year yields from 3.38 per cent to 3.92 per cent.
The Reserve Bank has been signalling, quite loudly, that there will be more increases in the cash rate to come, with its most recent minutes showing that it seriously considered a 50 basis point increase in the cash rate before settling on a 25 basis point rise. Financial markets are pricing in a peak cash rate of about 4 per cent. It is currently 3.35 per cent.
US investors will probably get a clearer insight into the Fed’s thinking on Thursday, when the minutes of the Fed’s most recent Open Market Committee (which sets the federal funds rate) are released.
They will be as closely scrutinised as any the Fed has produced, with some concern that they will show a more hawkish sentiment among committee members than investors and analysts have previously been led to believe from the Fed’s official statements and its chairman Jerome Powell’s public commentary.
If those concerns are confirmed, the mood in the markets will shift even more significantly from the “risk on” sentiment that has prevailed for most of this year to date – before investors began to question their convictions as positive economic news emerged – to one of increased risk aversion. That would test the resilience of the rebound in markets this year.
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Source: Thanks smh.com