For Stock Market Investors – Don’t Expect a Lull in the Stocks While Rates Chase Inflation.
Don't fight the Fed.
Sometimes all it takes is a sign perceived as positive for frightened investors to overreact in the stock markets.
We all saw this sign on Monday, October 3, 2022, with the release of the US ISM Manufacturing PMI. Rather innocuous, the slightly lower number nevertheless revealed surprising declines in the two components most closely watched by insiders: employment and new orders. That's all it took for investors to get a thrill, enjoying the news in an excessive, but instructive way.
During October 3 and 4, 2022 alone, 10-year interest rates eased by nearly 30 basis points in both the U.S. and Europe, a drop of unprecedented magnitude given the bullish environment since the beginning of the year: +2%. As for the stock markets, they appreciated by nearly 5% during the same period.
Again, a spectacular rise, given the downward trend in stocks since the beginning of 2022: nearly -20%. Since then, rates have recovered somewhat, and stock markets have eased somewhat. Nevertheless, this week's movements confirm two key facts, one that will surprise no one, the other perhaps more enlightening ...
The investor is comparable to the princess in the story of The Princess and the Pea
The first key fact is that interest rates are showing exuberant sensitivity. The slightest piece of news that might allay investors' fears is enough to make them excited. And it must be said that investors are worried: the Fed and the other central banks have decided to raise their key rates for the better (to curb inflation), but also for the worse (to stifle activity). From then on, the publication of the ISM had a small effect: investors ostensibly proclaimed immediate appeasement, as if pointing to the ISM was enough to mean the thing without saying it.
Nothing new. The extreme sensitivity of the markets has not surprised anyone for a long time.
There has always been a princess in an investor's eye like the one in the story of The Princess and the Pea. Markets are excessive, what else could they be? Even market efficiency allows for rational variations in the risk premiums demanded by investors ... In plain English, this means that the market has the right to collapse if the investor anticipates that the economic recession may cause him to lose his job and his savings at the same time. In effect, the investor cannot hedge against the risk of losing his job, but he can always hedge against the risk of losing his savings. And since this is all he can do, he will do it with all the more enthusiasm, hence the drops that may seem excessive to the layman.
Inflation brings the damaging power of rates back to the forefront
The second essential fact to remember is perhaps the first, because it sheds light on the mechanics of the stock markets and interest rate markets since the beginning of 2022.
This key fact is that interest rate hikes are, once again, the main factor justifying the decline in equities. The financial theorist will not find anything original in this case, since he knows that the value of a share must fall if the interest rate rises. Except that the financial practitioner will point out that this was no longer the case since the 2000s since interest rates tended to fall while stocks tended to do what they wanted.
The rather open-minded theorist will nevertheless challenge the antinomy. To do so, he will propose the intervention of a hidden variable that could justify the anomaly observed by the practitioner: the risk premium. “If stocks have disobeyed rates, it is because the risk premium demanded by the investor has muddied the waters,” says the theorist. “Great, and why isn't your risk premium acting today,” replies the practitioner.
Indeed, the premium does not seem to be acting today since rates are once again exercising their power to harm stocks. This debate is not as sterile as it seems, since, after long exchanges, theorists and practitioners will untie the Gordian knot of this matter. If rates are again causing worries for equities, it is probably because inflation is again causing worries for central bankers...
Indeed, it will be noted that during the last 20 years, inflation has disappeared from the radar.
The case of the United States is enlightening, with an unemployment rate that has reached levels well below the so-called natural level (NAIRU), without motivating any undesirable acceleration of inflation, or inflection of long-term inflation expectations. This disappointing inflation had the effect of disconnecting interest rates from inflationary risk and inviting the Central Banks to reorient themselves professionally.
Without a function, but not without an organ, these same Central Banks decided to use their rates not to fight inflation, but as a fire pump: in case of crisis, they lowered rates to 0%. The practice of ultra-accommodating monetary policies then had the effect of progressively suffocating long-term interest rates and thus annihilating their power to harm the stock markets.
But today, the return of high inflation is changing the game.
From now on, the Fed and the other major central banks must once again use their rates to fight inflation, and no longer save the planet. Rates have once again been given carte blanche to rise as much as they want. Rates are once again a threat to the stock markets. Hence the sharp decline in equities since the beginning of 2022, against a backdrop of significant increases in interest rates.
As long as the risk of inflation remains, the damaging power of interest rates on equities will remain. And since the current energy crisis does not allow us to anticipate an easing of inflation any time soon, it is reasonable to think that interest rates will continue to inhibit the stock markets for a while.
