Why markets know more than experts, and what they expect
Markets don't plunge over a long period of time without a reason. This year has been a terrible one for investors and since we're all investors one way or another, that's been bad for us all. Stock owners are investors, but so are homeowners. People who simply hold cash in savings accounts lost value to inflation. People who depend or will depend on social security saw the value of the social security trust fund decline in value, increasing the probability of some sort of default in the system.
Of course, many Christians don’t like the topic of wealth. They try to be more Christian than Jesus, who spoke often about money, investing, and economics. But economics is every bit as much a Christian topic as how to organize a church or how to have a good marriage.
One of Jesus' frequent economic subjects was the difference between owners and stewards and other forms of "hirelings." The parables often speak about this, for example the parables of the talents of or the unjust steward, which describe situations in which one person is in charge of taking care of something which is owned by another person. Jesus refers to such people as "hirelings" and suggests that they are tempted to be less diligent about the care of things they do not own than the owners will be.
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The Greek Orthodox mathematician, Nassim Taleb talks about the importance of "skin in the game" when it comes to assessing risk. People who suffer pain for being wrong, they will be less likely to make mistakes. The Christian economist, George Gilder argues in Knowledge and Power that a society is best organized when decisions are made by the people who are most directly affected by the quality of those decisions. Giving power to people whose mistakes affect others, and not themselves, is a mistake. These are modern restatements of an insight which Jesus anticipated 2,000 years beforehand.
Many Nobel Prize winning economists have had terrible track records as forecasters. Government economists often end up with more power after mismanaging things because recessions lead to bigger budgets for government. After 40 years in media, I've never seen a pundit lose his job for a wrong prediction, including me.
This is why I look closely at markets when it comes to forecasting the economy. Investors suffer real-world consequences for being wrong. Economists generally don't suffer for bad predictions. Investors aren't perfect predictors; only God knows the future. But when it comes to the world of mortals, those with skin in the game are better guides than hirelings.
Big Picture: Last week was a perfect example of our odd current economic dynamic. News which shows that the economy has been doing better than expected is interpreted as meaning that the economy will be doing worse than expected. That's because the Fed is the main engine of financial activity due to its enormous size as a financial actor. So, when the final report for GDP growth in the summer came in last week and it was both higher than previously reported and higher than expected, the markets saw that as giving the green light to the faction of the Fed that wants to focus on fighting inflation by slowing economic growth. Think of inflation as a cancer, monetary contraction as chemotherapy and last week's good GDP report as a medical test which markets think will be interpreted by the Fed as implying that the patient is healthy enough for another round. But the patient isn't so sure and last week signaled through a pattern of anti-growth trades that recession risks are rising. That's how good economic news now means bad economic news later.
In response to the GDP shift, the typical hawk pattern of trading occurred:
- The futures market shifted slightly toward expectations of bigger hikes.
- The CME (Chicago Mercantile Exchange) Fed Watch Tool shifted in such a way as to imply that if the predictions of future hikes turn out to be wrong, the hikes will more likely be larger than expected rather than smaller.
- Gold fell.
- Inflation hedges lagged non-inflation hedged investments.
- Markets in general fell.
However, the dollar did not rise in accordance with the typical hawk trade. We'll see below evidence that this fits with other market indicators showing that markets are continuing to shift towards believing that the US will not be avoiding the global recession.
Usually the hawk trade is accompanied by anti-growth trades Markets surmise that monetary tightening might shrink the economy. That's because hawkish policy is designed to slow the economy to fight inflation.
Last week was mixed in terms of broad asset classes when it comes to anti-growth trades:
- Stocks were generally negative.
- Bonds were more negative.
- Which means stocks significantly outperformed bonds, a pro-growth trade.
- Commodities rose, a global pro-growth trade.
However, as we shall see in the detail below, the comparative returns within asset classes (e.g. one sector of stocks vs. another; one class of bonds vs. another, etc.) and the variations between sectors were almost universally anti-growth.
This coming week, there are not many economic indicators scheduled for release. There will be some housing market data, and the usual weekly unemployment claims.
Bonds Last Week: Stocks generally outperformed bonds, which constitutes a pro-growth signal. However, variations between the different types of bonds were generally sending anti-growth signals.
Bond markets were generally down last week, which fits the narrative of a tougher, hawkish, Fed. After all, if the Fed is going to be selling more bonds (or at the very least buying fewer bonds), it's no surprise for bond investors to see that as bad news for that asset class. The macro-economic implications of that expected shift in policy become clearer by taking a higher-resolution look at the data, turning the magnification level up to see how different types of bonds reacted.
Treasury bonds, the ultimate safety play, overperformed high-credit-quality corporate bonds, which are considered a little riskier. That's an anti-growth trade: when business slows down, companies find it harder to make their debt payments, but the government can always tax or print more. So, corporate bonds are more likely to default and forward-looking investors sell them now rather than risk being left holding the bag if a company defaults on its debt service payments. Last week, markets acted as though growth might not be high enough for well-financed corporations to make those payments. That's called 'risk off'.
However, low-credit-quality corporate bonds beat treasuries. That's usually seen as a pro-growth trade, a 'risk on' trade. If investors are driving down the price of 'super-safe' treasury bonds more than 'junk bonds', they must be getting more confident about growth, right? Well, maybe not. High yield bonds are at higher risk of default during slow-downs, but they can sometimes get bailed out by inflation. Inflation helps debtors at the expense of their lenders, because the borrowers pay back dollars which are worth less than the dollar they originally borrowed. The bigger the debtor, the more help. High yield bond companies (aka 'junk bonds') are bigger debtors than regular corporate bonds, so an inflation tail-wind helps them more. And, it just so happens that last week, despite generally being a hawkish, Fed tightening week, inflation-hedging treasuries overperformed their non-inflation-hedging alternatives. That means that last week, the purest expression of inflation risk, the spread between two investments that are alike in every way except for how they compensate investors for inflation, showed investors getting more worried about inflation. Markets are just not convinced that the Fed can beat inflation.
Real Estate Last Week: REITS performed negatively. This was consistent with an anti-growth trading pattern, since real estate values depend on the ability of renters to grow enough to pay their leases. Even more relevant is the dependence of RE on low interest rates. Since last week's trades implied that the Fed would hike more in the future, it is natural that RE values would drop. REITs have a slight tendency to perform between stocks and bonds, but slightly closer to equities, which is what they did last week.
Stock Markets Last Week: Domestic equity markets were generally down last week, but unevenly so.
Growth stocks lagged value stocks across all three size categories.
What we wrote previously continues to hold true a week later:
"Growth tends to beat value when growth expectations are rising, because low growth presumably makes it harder for earnings to actually deliver on growth companies' high expectations. So, the weak growth performance is consistent with the anti-growth trades. That is indeed likely, because the pattern last week showed a pretty consistent anti-growth signal.
On the other hand, the weak performance of growth stocks might have been driven by rising interest rates. Growth stocks are more dependent on low interest rates than value stocks, so consequently, they also tend to underperform value stocks when interest rate expectations are rising. Their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings. Whatever the interest rate expectations, whether higher or lower, they tend to have a larger effect when it is applied over a more years of discounting. Since growth stocks prices are based on a longer time horizon, they tend to fluctuate more in response to interest rate expectations about the future. The value-expanding effect of low rates helps companies whose investment premise is based on the long view more than those whose investment premise is based on the short view. Since last week was about a shift towards higher rate expectations, it's no surprise that growth lagged value. That's what basic theory and history would teach us to expect.
It's honestly hard to know how much last week's growth-vs.-value performance was about the Fed changing the valuation of stocks by changing the interest rate, or about the Fed triggering a recession. Causing a recession implies future cash flows will be lower. Raising interest rates means that future cash flows will be discounted more deeply. Both of those things hit growth stocks.
But if one looks at the difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, and discretionary/utilities, one sees a pretty consistent anti-growth trade. Plus, last week interest rate expectations did not rise consistently. All this suggests domestic stock performance last week is more about the rising probability of a recession than it is about the discounting effects of rising rates. In other words, it's more a recession warning. VUSE overperformed the S&P and other similar indices, which makes sense given that last week value led growth, and VUSE is overweight to value. It also makes sense given that mid and small cap outperformed large cap and VUSE is underweight large cap relative to cap-weighted indices."
Global Stock Markets Last Week: International equity markets were up for the week. In general, U.S. significantly lagged global markets in price returns. Partly that was a fall in the value of the dollar, but that fall was modest, and not enough to account for U.S. underperformance based on currency effects alone.
That's probably not due to direct interest rate effects, because EM tends to be more sensitive to rising US rates, as capital flows to places where it can get a higher yield and EM is more volatile and therefore more vulnerable to such outflows. So the normal effect of rising U.S. rate expectations would be to weaken EM relative to DM. The fact that this is not what happened last week during a week of hawkish trades, indicates the EM performance was likely due to a shift towards more global growth optimism. That would also fit with the fact that last week was good for the commodities complex. So markets have continued to believe the U.S. will not likely avoid the global slowdown which markets have been registering this year.
So, as we come into the final days of the year, we see that those with skin in the games, expect that skin to feel some pain in the year ahead.
Jerry Bowyer is financial economist, president of Bowyer Research, and author of “The Maker Versus the Takers: What Jesus Really Said About Social Justice and Economics.”
