What are investors concerned about ….inflation or recession…or both?

In the aftermath of the Great Financial Crisis (GFC), I began to observe a new phenomenon in the equity markets. It seemed to be that whenever there was bad news economically, the stock market went up. The bad news was good news for equities. Why? Investors were focused on the reaction of the Federal Reserve to the bad news– so bad news in the economy meant a more dovish Fed policy and higher stock prices.  This also happened in the wake of the COVID-19 period in which the Fed was very accommodating in the face of bad economic news. If we look at today’s markets, we are in a similar situation but in reverse. During the current inflationary period, if the economy shows signs of strength or employment numbers are relatively strong, which typically would be considered good news, the equity market often interprets this as bad news because it may mean that the Federal Reserve will continue raising rates beyond current expectations. As we have seen throughout 2022, good news in the jobs market has been bad news for the equity markets based on the expectation that the Federal Reserve will be focused on raising rates to fight inflation.

At this point, in late December 2022, it appears that investors are becoming comfortable with the idea that inflation peaked at 9% in June of 2022.  But it’s still running at too high a rate- and investors now expect the US central bank to keep raising rates into 2023, although that pace is likely to slow from what it has been. It appears that a new concern has taken over: the potential for a recession in 2023. Using the same logic as prior periods, a recession could be viewed as “bad news” that is actually considered good news, because the Fed may be more accommodative.  But investors appear to be concerned with both rate increases and a recession happening at the same time in early 2023.  So, we may be switching back to the bad news is actually bad news paradigm. For example, somewhat weak retail sales in December have sent equity markets lower.

Back in the 2009-2010 period, the belief in a “Fed Put” was widely held by market participants. That is, if the economy did well, then that was good news for stocks; but if the economy faltered, the Fed was expected to step in and be accommodative – also good news. The bad news was good news and the good news was good news.  In the current market environment, the opposite appears to be the case; if the economy is strong the Fed may tighten more than currently expected, and the equity markets will go lower. A Goldilocks scenario in which inflation comes down and we avoid a recession (aka soft landing) is still a possibility but seems less likely.  So, investors appear to be focused not only on the problem of inflation but also on the prospect of a recession at the same time. The key question now is:  will this be a permanent situation? If history is any guide, certainly not.  Our view is that eventually, although the timing is not certain, inflation will fall. The Federal Reserve will stop raising rates, and economic activity will resume. And equities will begin their long-term ascent higher. The difficulty of course is staying invested during periods like this.  It is important to rebalance back to targets because no one knows when things will change.  Discipline is the key to long-term investment success. Please let us know if you have any questions about your portfolio.

Happy Holidays!

Published Works

Over the past twenty years, Michael has written five books on behavioral finance and emotional investing to help clients make better investment decisions and reach their goals. His latest work below on the left is designed to help individuals recognize and better manage their behavioral investing biases in any stage of life or market environment.

Available on Amazon
Available on Amazon
Available on Amazon
Available on Amazon
Available on Amazon