Strong economic data is generally considered good news. When the economy is growing, consumers are spending, companies are producing more, employment is usually strong and corporate revenues and earnings have the potential to increase. It therefore seems logical that stronger economic growth should be positive for the stock market.
Yet financial markets do not always react that way and yesterday’s US PMI data provided a good example. The Flash US Composite PMI showed that economic activity accelerated sharply in September, with growth reaching its strongest pace since 2021. At the same time, however, the survey showed renewed increase in price pressures, with input-cost growth reaching its highest level in almost four years. The combination of stronger growth and higher inflationary pressures led markets to increase expectations for further Federal Reserve tightening. Treasury yields surged and the S&P 500 sold off.
So, if the economy is growing faster than expected, why would traders sell stocks? The answer is that the stock market is a reflection of expectations about the future and that’s why context matters.
The stock market is forward-looking
Stock prices represent the value investors assign to future corporate earnings and cash flows. Investors are therefore constantly trying to gauge whether their companies will grow more or less in the future and express their ideas by buying or selling shares. Stronger growth can increase demand for goods and services, helping companies generate higher revenues and potentially stronger profits. This is positive for equities.
On the other hand, stronger growth can increase inflationary pressures and at some point require monetary policy tightening to slow the economy down. That increases borrowing costs, pushes Treasury yields higher and raises the discount rate used to value future corporate earnings. Ultimately, it leads investors to revise their future growth expectations downward, which in turn leads to deleveraging and selling pressure.
Financial markets are constantly pricing and repricing future expectations.
Rising Treasury yields are not always bad for stocks
It is also important not to make the mistake of assuming that higher Treasury yields are always negative for equities. The reason yields are rising matters. The first thing you should know is that short-term yields are mainly driven by near-term monetary policy expectations, while long-term yields are basically a bet on future monetary policy path plus inflation expectations and a term premium.
So, suppose the economy is accelerating after a slowdown because demand is strengthening and the central bank cut interest rates, while inflation remains contained. Investors may raise their expectations for future corporate earnings, while Treasury yields rise because the economy is healthier and could lead to higher inflation and interest rates in the future.
In that environment, higher yields can coexist with rising stock prices because investors are focused on the improvement in expected earnings and there’s low risk of high inflation and rate hikes in the near future.
The problem arises when Treasury yields rise because investors expect higher inflation and tighter monetary policy. In that case, the increase in yields represents a higher cost of capital and a higher discount rate for future earnings. The market can therefore become concerned that the Federal Reserve will have to slow the economy in order to bring inflation back under control, which will ultimately weigh on future earnings growth expectations.
This distinction between a growth-driven rise in yields and an inflation- and policy-driven rise in yields is crucial for understanding the relationship between bonds and equities.
Why weak data can sometimes be good for stocks
Weak economic data are generally negative for corporate earnings because slower growth means weaker demand and lower revenues. Yet weak data can sometimes trigger a positive reaction in the stock market if investors believe the deterioration will lead the Federal Reserve to cut interest rates.
This is the logic behind the famous market saying that “bad news is good news”. Investors start to expect better economic growth thanks to the central bank help. This is another example of the stock market being forward-looking.
This is also why valuation analysis is meaningless. Stocks with negative earnings can still rise substantially if investors expect the companies to lose less, then break even and eventually become profitable. This is the whole purpose of buying low and selling high.
This article was written by Giuseppe Dellamotta at investinglive.com.