Above the Noise: Markets suggest inflation story is over

“The enemy is noise. The goal is clarity.”

– Jon Stewart

It’s hard to name things. My wife and I struggled for 40 weeks during each pregnancy to come up with baby names. ?Yet, I didn’t labor (see what I did here?) to name my monthly newsletter. I wanted the content to rise above the noise to focus on what mattered most for financial markets, and I named it accordingly.

The cacophony is almost always deafening but perhaps not as earsplitting as it is today. Wars. Elections. Hurricanes. The latest celebrity conspiracy that I can’t follow but my teenage daughter obsesses over. It’s a lot. Still, as I type this, the Dow Jones Industrial Average and the S&P 500 Index are at all-time highs.

How can that be? ?To stay above the noise, I focus on three main drivers for the market:

1. State of the business cycle
2. Direction of the economy
3. Likely course of monetary policy

Unless the wars, the elections, or the natural disasters change my view of these three market drivers (they typically don’t), then I view them as noise as it relates to the market. Investors overly focused on politics and/or geopolitical conflict may have missed the economy’s remarkable resilience and the commencement of the much-anticipated Federal Reserve (Fed) easing cycle.

Should we name it a soft landing? A Goldilocks environment? Call it what you will. Either way, I expect the backdrop for risk assets will likely remain positive.

It may be confirmation bias but…

…good news is good news, and bad news is bad news again.

Let me explain. When inflation was elevated, good news for the economy was viewed as bad news for the stock market as it signaled that policy tightening would continue indefinitely. Now, with inflation contained, the markets have turned their focus away from inflation to growth and have generally rewarded good economic activity.

How do we know? Consider the rolling correlations between stocks and US Treasuries, which are illustrated in the chart below. Historically, the two, on average, have been negatively correlated, meaning that when one goes up, the other goes down, and vice versa. That had not been the case between late 2023 and mid-2024. During that period, good economic news meant higher rates (lower bond prices) and poor equity performance, while bad economic news meant lower rates (higher bond prices) and strong equity performance. It appears those days are over as the correlations have once again turned negative, meaning that when stocks go up, bonds go down, and vice versa. (1)

Good news is good news again. It suggests that the markets believe the inflation story is over. And that’s, well, good news.

When correlations are negative, bad news for growth is bad news for stocks

Since you asked (part 1)

Q: Why didn’t higher interest rates impair the US economy, as is often the case?

A: The simplest explanation is that most Americans have fixed rate mortgages. As the chart below shows, the rate of new mortgages has surged while the rate that Americans pay remained historically low. American households had taken advantage of the low-rate environment from 2009 to 2021 by locking in interest rates for 30 years. (2)

If the Fed raises rates and most don’t notice it, then it doesn’t make much of a sound. ?

New mortgage rates have soared, but many Americans locked in their low rates years ago

Since you asked (part 2)

Q: Given that the US excess savings rate has declined significantly, how will the US consumer be able to continue to support the economy?

A: I’ve heard this question a lot. Excess savings have been depleted. Think of that as savings that households wouldn’t have without the sizeable government response to the pandemic. The situation is much better for US households than the question implies. Consumer net worth is at an all-time high, (3) and there are still nearly $18 trillion in bank deposits (4) and $6.5 trillion in money markets. (5)

It was said (part 1)

“One month does not make a trend.”

– Claudia Sahm

Sahm, a labor market expert, cautions against reading too much into September’s job report. The outsized payroll report is inconsistent with other readings suggesting that the US job market is cooling. For example, job openings have fallen to a pre-pandemic level, while quit rates, which tend to decline as jobs become harder to find, are lower than they were in 2019. (6) So much for the great resignation! I’d also note that payroll numbers are prone to heavy revisions.

The strong payroll report drove US Treasury rates higher and reduced rate cut expectations. (7) It’s likely overdone. I’m with Sahm on this one. Let’s not put too much into one number. The easing cycle will persist.?

It was said (part 2)

Have you heard the one about the markets preferring divided government? Of course you have. Is it true??Admittedly, the numbers do bear it out although I would argue the analysis isn’t statistically significant. Rather, the returns in most instances tend to be driven by a handful of notable years. Let’s look at two potential 2024 divided-government outcomes:?

• Republican President, Republican Senate, Democratic House: This combination has resulted in the second-best outcome for stocks. (8) It’s an interesting tidbit, especially for those hoping for a Trump victory, but is less impressive when we consider that combination has only happened during the early Reagan years and in 2019-2020.?
• Democratic President, Republican Senate, Democratic House: This combination hasn’t happened since 1886-1889, leaving it out of the period of our analysis.???

For what it’s worth, the US stock market posted positive strong returns in recent examples of single-party rule, including under Democrat Bill Clinton (1993-1994), Republican George W. Bush (2005-2006), and Democrat Barack Obama (2009-2010). (8)

Everyone may “know” that the market does best under a?divided government, or everyone might just be confusing correlation with causation.

It’s that time again?

Here’s my public service announcement on the eve of the election. Markets don’t care if you don’t like the president. In fact, since 1961, the market has performed best when the president’s approval rating was between 35 and 50. (9) Look no further than S&P 500 returns under Obama, Trump, and Biden, who had approval ratings between 35 and 50 for 74%, 100%, and 82% of the time, respectively. (10)

So, if you and your friends and family aren’t happy with the outcome, just remind yourself and them that the market prefers it when more than half of the country doesn’t approve of the president.

Automate my job?

Each month, I pose a question to ChatGPT — the artificial intelligence-driven chatbot — and assess the response.

Q: What are the conditions that would result in a weaker US dollar?

A: A weaker US dollar can result from several economic conditions and factors, including:

1. Low interest rates: If the Federal Reserve keeps interest rates low or lowers them further, it can reduce the dollar's appeal to investors seeking higher returns.
2. High inflation: Persistent inflation can erode purchasing power, leading to a decline in the dollar's value compared to other currencies.
3. Trade deficits: A large trade deficit, where imports exceed exports, can put downward pressure on the dollar as more dollars are sold to purchase foreign goods.
4. Global economic growth: If other economies are growing faster than the US economy, investors might prefer to invest in those currencies, leading to a weaker dollar.

Good answer, ChatGPT. I’d focus on 1 and 4. Investors had been expecting US growth and rates to decline, converging with the rest of the world. The recent strong economic releases have suggested otherwise. Nonetheless, I’m still in the camp that easier monetary policy should result in a moderation in the US dollar, providing support for non-US dollar assets.

Everyone has a podcast

Our Global Head of Public Policy, Andy Blocker, recently joined the “Greater Possibilities” podcast to break down the complex concerns investors are facing as they prepare to cast their ballots. ?Please have a listen.

On the road again

My travels this month took me to Oakland County, Michigan, and Maricopa County, Arizona, two places that will be in the spotlight on election night. I wasn’t prepared for the onslaught of campaign advertisements that were bombarding the airwaves. It felt like every other commercial was asking me for my vote. I suppose I’ve identified a benefit to not living in a swing state.

It’ll all be over soon. Remember, we have more commonalities than we have differences. Take it from someone who is always on the road in this great country.

See you on the other side of the election.

1. Sources: Bloomberg L.P. and Invesco, 9/30/24. US Treasury (7-10-year) returns are represented by FTSE US Government Bond 7-10 Years Index. Statistics calculated using daily returns data beginning January 1993. Index returns do not represent strategy returns. An investor cannot invest directly in an index. Past performance does not guarantee future results.
2. Sources: Bureau of Economic Analysis and Bankrate.com , 9/30/24.
3. Source: US Federal Reserve, 6/30/24.
4. Source: US Federal Reserve, 10/2/24.
5. Source: Investment Company Institute, 10/9/24.
6. Source: US Bureau of Labor Statistics, 9/30/24.
7. Source: Bloomberg L.P., 10/15/24. Based on the 10-year US Treasury rate and fed funds futures.
8. Source: Bloomberg L.P., 9/30/24. Based on the performance of the S&P 500 Index.
9. Sources: Bloomberg L.P., Gallup, and Invesco, 9/30/24. Based on the performance of the S&P 500 Index during periods when the approval rating is below 35, between 35 and 50, and above 50.
10. Source: Gallup, 9/30/24.

Important information

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Image: Balefire9/Getty

All investing involves risk, including the risk of loss.

Past performance does not guarantee future results.

Investments cannot be made directly in an index.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal?debt issued by the US Treasury.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Correlation is the degree to which two investments have historically moved in relation to each other.

The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange.

Monetary easing refers to the lowering of interest rates and deposit ratios by central banks.

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

Inflation is the rate at which the general price level for goods and services is increasing.

The S&P 500? Index is an unmanaged index considered representative of the US stock market.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The opinions referenced above are those of the author as of Oct. 22, 2024. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.