This week the world waits to hear what decision the Fed, America's central bank, will make about whether to hike rates and if so, by how much. For several weeks, forward-looking estimates about what the Fed will do have been the major factor determining market behavior. The Fed is now the single largest buyer or seller of investments with a portfolio of over $8 trillion. This means that this quasi-governmental agency and its decisions are now more important to markets than actual economic or business conditions. The Fed is the thumb on the scale, distorting the value of currency, and of entire asset classes, violating the principle of just weights and measures on a daily basis.
Looking at last week, which was the last full week before the Fed announcement, we see the pattern unmistakably: markets absorbed economic news not in terms of what they mean in and of themselves, but in terms of which ways the winds would blow in terms of our volatile double-minded central planners.
Big Picture: Last week was largely about the monthly inflation report, which said that even though inflation had dropped somewhat, it hadn't dropped as much as expected. There were other economic reports of interest: wholesale inflation (fairly mild); retail sales (slightly up); industrial production (slightly down); two regional manufacturing surveys (lowering forecasts), and weekly unemployment claims (continuing to improve). The inflation and unemployment reports were the most decisive events of the week. And both of those sent the same signal: that the Fed would keep fighting inflation because inflation is still high, and the Fed has the room to fight inflation without creating too much unemployment because the labor markets are strong.
This triggered the standard market dynamics we've seen whenever markets believe the Fed will take a tough love approach: interest rate hike probabilities rise significantly, along with other bond yields. Bonds sell off, but stocks sell off more. Inflation-sensitive asset classes such as gold, crypto currencies, inflation-protected bonds, and foreign currencies drop. Industrial commodities (which are sensitive to both inflation and growth) drop. Last week followed that tight Fed playbook to the letter.
These comparative returns between asset classes such as stocks, bonds, currencies, and commodities continue to fit the story of lower U.S. growth, lower global growth, and slightly lower inflation expectations. We'll see below whether the comparative returns of different sectors within asset classes also told the same story as the comparative returns between asset classes. Spoiler: they do.
This coming week is Fed Week, with the FOMC meeting and then an announcement of what will almost certainly be another rate hike of at least 75 basis points. We'll also get new housing data and, of course, weekly unemployment claims. Any one of those items has the potential to either intensify, or reverse, the narrative and the market dynamics along with it.
Real Estate: REITS performed poorly last week, as one would expect given the prevailing themes of the week. REITS do well with inflation (real estate is an inflation hedge); growth (because in seasons of higher growth renters can afford to pay more); and low interest rates (because it is a debt-dependent sector). And last week markets concluded that all of those pro-REIT conditions were becoming less likely. REITs performance is typically between that of equity markets and bond markets, however last week it fell short of both, likely because of the three factors mentioned above.
Stock Markets: Equity markets were strongly down for the week.
Growth stocks tend to underperform value stocks during times of falling economic growth expectations (because growth presumably helps earnings actually deliver on growth companies' high expectations). Last week both styles were weak performers, but growth was weaker. Nasdaq's QQQ Index underperformed the S&P index, which underperformed value indices. In general funds which use valuation (buying low) and take an all-cap approach (meaning not artificially limiting themselves to large household name companies) were less down than the alternatives. And that pattern fits the prevailing theme of the week: a deteriorating growth outlook.
The various sectors also acted consistently with the deteriorating growth outlook: cyclicals underperformed staples and utilities (both recession hedges). Materials fared particularly poorly, due to falling industrial commodity prices, another anti-growth trade.
International Stock Markets: International equity markets were down for the week, but significantly less so generally then domestic equity markets. This happened despite the rising dollar. In other words, the international overperformance would have been stronger if not for the underperformance of the currencies in which foreign markets are denominated.
EM overperformed DM. Funds with an overweight to EM and all-cap and value stock picking within countries tended to overperform cap-weighted international funds, which put more money into bigger countries and then bigger companies within those countries.
Bond Markets: Bond markets were down last week, consistent with the macro outlook discussed above; the Fed hiking rates is bad for bonds because literally the way the Fed hikes rates is by selling enough bonds to make the price go down.
But the real story is found by comparing different types of bonds, at individual sectors. The story was consistent with decelerating growth (just as the stock sector dynamics we described above were), with high yield bonds and investment-grade corporate bonds significantly underperforming treasuries.
On the inflation side, TIPS underperformed non-inflation-protected treasuries, and the yield spread between them narrowed, which is an indicator of a lowering of inflation expectations. This concurs with the anti-inflationary message of a rising dollar, falling gold, and falling cryptocurrencies.
In the long run it is doubtful that inflation will be contained. Debt and spending levels have risen to the point where the government "needs" the central bank to continue to create money and lend it to the treasury. The governing class lacks the moral compass to see inflation as not only an economic problem to solve, but also a moral violation to repent of. Therefore, although current market conditions are forecasting the Fed taking a tough enough line to cause a recession, long-term it isn't clear that government planners will stick to monetary discipline when the economy sees a serious slowdown.
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.”