For this entire 21st century developed country markets have become used to a way of operating that would not make sense in any other era: that bad news for the economy is good news for equities. This flies in the face of all rational sense but it has become a truism. That is, until now. We might be entering a new are where bad news really is bad news and not a buy on dips opportunity.
An article in CNN Business states it succinctly: “There’s been a seismic shift in investor perspective: Bad news is no longer good news.” I have been pointing out in these articles for some time that central banks (particularly the US Federal Reserve) are no longer catering to the effects on asset markets when setting rates. Not because they don’t want to, but because it no longer an option for them.
Since the attack on the twin towers (an apt example of bad news if there was any) the US fed has instituted an unsaid policy of the “Fed Put” which essentially acted as a backstop for asset markets. The “put” initially meant a drastic fall in administered rates which ensured that equity and property markets got a boost. After the financial crisis of 2008/9 when banks were unwilling to lend to main street the Fed also flooded the markets with liquidity. Banks were still unwilling to risk lending to corporates so the best outlet was the equity markets. This steroid combination -of ultra-low rates and high liquidity, is a large contributor to the valuations we see in the markets. Housing markets and equity have been the beneficiary of this largesse for over 20 years now.
Which is precisely the reason that it is taking market players so much time to realise that this is no longer the case. There are probably only a few experienced hands left in the dealing rooms around the world who would have familiarity of trading bad news for what it was: bad news. So, when the latest crisis to impact the world economy rolled around- the 2020 pandemic, and countries went into lockdown, factories slashed output, the initial panic sell-off was immediately countered by the flooding of the zone with additional liquidity- the Fed itself added US$ 5 trillion to its balance sheet in the aftermath. So far it was exactly according to the playbook and equity prices surged across the globe despite the likelihood of production targets being missed and sales being poor.
What changed this time was the resurgence of something not seen for a long time- inflation. Most OECD banks had set themselves inflation targets of 2% and were struggling to get it that high. Of course, the disinflationary aspect of outsourcing to China had a lot to do with that. So, when Chinese goods were not readily available due to supply chain breakdowns, container rates surged to ten times their pre-pandemic rates inflation started surging. The central banks ignored this, saying that it was a temporary blip- which it turned out not to be.
The Russian invasion of Ukraine and its impact on food and energy prices added to the price spikes- aggravated by corporate profiteering, which helped keep share prices high. But- a little late, the central banks realised that the inflationary pressures were not going to be short-lived and decided to act in the only way they understand- tighter monetary policy. And we are now seeing the resolve behind their decisions.
Fig. 1: US Federal Reserve Balance Sheet size in US$ trillions
Source: Statista.com
The graph above highlights the lesser known part of the Fed’s actions: they have begun shrinking their balance sheet. From a peak at US$ 9 trillion it is down at US$ 8.34 trillion (as of March 8, 2023). They are likely to continue this downward trajectory since monetarist policy tells us that excess liquidity fuels inflation.
The more visible actions are the continuation of their rate hikes despite there having been a number of medium sized bank failures over the last few months. That would have been usually when the Fed would have cut rates and injected liquidity. Well, times have changed. The Fed hiked rates in their first meeting after the bank collapses- after guaranteeing that depositors would get ALL their deposits back- an ad hoc measure designed to prevent a run on confidence in the industry. And, with the latest set of strong labour market trends the likelihood is ever higher of a further rise in rates soon.
The market is now no longer looking to the Fed to cut when data is soft. So, even if there are signs of economic recession ahead it is unlikely that the Fed will allow ultra-loose conditions to again become the norm. The inflation genie is out of the bottle and central banks the world over are looking to bring it to below their mandated levels. The fact that inflation has also allowed governments to shrink the Debt: GDP ratios brought about by high fiscal largesse is only part of the consideration: central banks have one primary responsibility and very limited tools to act with.
The upshot of this is that- after an eternity- in terms of a batch of traders and investors, the central banks have changed tactics and are now less concerned about asset market valuations and more about the real world effects of limitless liquidity and low rates. The intended beneficiary- the economy, has not always felt the benefit of the medicine whereas the asset markets have made out quite well. The markets still go their knee-jerk response of bad news equals good news but that time may have now passed and they will have to re-learn the old-fashioned way of generating returns: by spotting winners in a healthy economy.