Robust economy may rattle stocks if inflation appears

Robust economic indicators are typically seen as positive. Growth in the economy means higher consumer spending, increased production, strong employment, and potential gains in corporate revenues and profits. So it would appear reasonable that accelerating economic expansion would benefit equity markets.

However, markets don't always respond as expected. Yesterday's US PMI figures illustrated this. The Flash US Composite PMI indicated a sharp acceleration in activity during September, marking the best pace since 2021. Yet the survey also revealed a resurgence in price pressures, with input-cost increases hitting levels not seen in nearly four years. This mix of stronger growth and rising inflation prompted markets to anticipate more Fed tightening. Bond yields jumped and the S&P 500 declined.

Given faster-than-expected growth, why would traders sell equities? The reason is that stock markets reflect forward-looking expectations, making context crucial.

Stock markets anticipate future conditions.

Share prices reflect what investors believe about future earnings and cash flows. Thus, investors continuously assess whether firms will grow or shrink and act by purchasing or offloading shares. Faster growth can boost demand for products and services, enabling higher revenues and possibly greater profits. That benefits stocks.

Conversely, rapid growth can fuel inflation, eventually necessitating tighter monetary policy to cool the economy. That raises borrowing expenses, lifts Treasury yields, and increases the discount rate applied to future earnings. Eventually, investors lower their growth expectations, triggering deleveraging and sell-offs.

Markets continuously price and reprice anticipated outcomes.

Higher Treasury yields don't always hurt equities.

Avoid the error of thinking rising yields are invariably negative for stocks. What drives the yield increase is key. Short-term yields primarily reflect expectations for monetary policy in the near term, whereas long-term yields incorporate the anticipated policy trajectory, inflation outlook, and a term premium.

Consider a scenario where growth picks up after a slump due to rising demand and a central bank rate cut, with inflation under control. Investors might boost earnings forecasts, and yields climb because the healthier economy could eventually produce higher inflation and rates.

In such a situation, yields and stock prices can both advance, as investors concentrate on earnings improvements and the near-term threat of inflation and rate increases is minimal.

Problems emerge when yields rise due to inflation and monetary tightening expectations. Then, higher yields mean a greater cost of capital and a steeper discount on future earnings. Markets grow anxious that the Fed will need to rein in growth to contain inflation, eventually dampening earnings growth forecasts.

Recognizing whether yield increases stem from growth or from inflation and policy is essential to grasping the bond-equity relationship.

Occasionally, weak data lifts stock prices.

Soft economic figures typically hurt earnings by indicating sluggish growth, reduced demand, and lower sales. But occasionally, weak data sparks a rally if investors think the slowdown will prompt the Fed to lower rates.

That reasoning underlies the well-known adage 'bad news is good news'. Investors anticipate improved growth aided by central bank action. This again shows markets look ahead.

This also renders valuation analysis irrelevant. Shares of unprofitable firms can surge if investors foresee narrowing losses, then breakeven, and eventual profitability. That is the essence of buying cheap and selling dear.