The easy narrative after Friday’s blowout jobs report was that good news on the economy is bad news for stocks, as bond yields jumped and the S&P 500 (.SPX) tumbled. As soon as bond yields stopped going up, stocks began to recover. There’s an important lesson in that action.
Bad news on the economy had been good for stocks for several weeks; downbeat views on the economy raised the chances of an interest-rate cut, thus goosing a rally that has run since the beginning of June. And the fresh bit of good news in the jobs report could be bad news for a little while as higher bond yields reverse more of the recent stock-price rally.
But it would be a mistake to put much faith in the good-news-is-bad story for long.
Believing in it requires thinking either that inflation is about to be a problem, or that the Federal Reserve is about to err on the side of hawkishness. Both are possible, but neither seems likely in the near future.
The best framework for thinking about this is the dividend discount model: the value of stocks today is the value of future dividends or profits, discounted back to today’s money at an appropriate rate, usually using bond yields.
As yields go up, the value today of future income from stocks goes down. But if the economy is expected to do better, there will be more future income. If a stronger economy leads to higher yields, the two can cancel out. Higher yields are bad news only if they are going up for reasons other than faster economic growth—for example, to kill off too-high inflation, or because the Fed is making a hawkish mistake.
A parallel to the discount model is to split stock prices into two components: future earnings per share and the valuation of those earnings. If rates go up, the valuation—the price-to-earnings ratio—should fall, because future earnings are worth less. But if the economy improves, earnings should go up, offsetting the falling valuation.
We’re still in the benign situation where bond yields go up because the economy’s doing better. After the strong jobs figures, the Federal Reserve is expected to cut rates less this month than it was before, and two-year Treasury yields rose by the most since 2015, having their second-biggest one-day rise in a decade.
A plausible explanation for why stocks took the good news so hard is that the S&P 500 had been driven up by a Fed that investors hoped was going to be unnecessarily dovish, pushing through a hefty cut in rates as a form of insurance at a time of below-target inflation. The expectation of lower rates without any offsetting economic weakness is good for stocks; reversing it, as Friday’s move did in part, is bad for stocks.
One piece of evidence: the recent rally had been led by defensive stocks as yields fell, while on Friday and Monday economically sensitive consumer discretionary stocks beat reliable consumer staples. Other sectors weren’t so clear-cut, but investors certainly didn’t rush for traditional havens within the market.
There’s scope for a bit more of the recent equity rally to reverse and share prices to fall, as the S&P is still 9% above its low of June 3; but with two-year Treasurys already back to where they stood then, there shouldn’t be much more purely yield-driven selling to come.
That means for the pattern of good news being bad for stocks to continue, investors will have to start worrying that yields will keep going up without signs of a stronger economy. That takes either a return of persistent inflation, or a change of tack by the Fed.
Frankly, there’s no sign of persistent inflation. I’ve long been expecting the tight labor market to feed through into wages, and it has to some extent. Average hourly earnings in the private sector rose more than 3% in June compared with a year earlier, as they have since October. But they appear to have decelerated since February, and there’s little indication of higher wages feeding through into prices.
Perhaps companies aren’t passing on higher costs because they have such elevated profit margins they can afford to absorb somewhat higher wages. Perhaps spare capacity in the economy makes it hard to raise prices without being undercut by rivals. Or perhaps, in an era of global online shopping, consumers can compare prices and shop elsewhere more easily.
The idea that the Fed is suddenly going to turn hawkish is even more laughable than the idea of worrying about inflation any time soon. One of Donald Trump’s latest nominees for the Fed wants to cut rates, and the other currently works for the dovish St. Louis Fed President James Bullard, who voted to cut rates at the last meeting.
The true danger for shareholders isn’t that good news pushes up rates, but that bad news reawakens the recession fears that trashed the market in December. Bad news on the economy, after all, is usually just bad news for stocks.
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