“So where does all this leave Fed policy? Confused, I think.” – Tim Duy, Economist’s View blog
We have often argued that chaos theory has a lot to teach us about global economics. The seemingly infinite confluence of factors all intersecting in the economic space time continuum make it very difficult to decipher what current data means for the future. Even the top economic officials, and those in policy making positions, have a hard time reading the tea leaves beyond identifying large scale macro trends in real time.
Clearly there are the occasional imbalances that become so extreme they are hard not to notice. There were plenty of smart observers, for instance, who correctly identified the subprime mortgage bubble before it burst, triggering the global financial crisis. But even in that instance there were many smart economic players (Ben Bernanke for instance) who looked at the same data and reached a vastly different conclusion than the naysayers. Otherwise the bubble probably wouldn’t have been allowed to inflate!
Taken a step further, to the extent it is difficult to predict the economy it is even harder to predict what response the financial markets will have to the economic data.
The September jobs report provided an interesting example of how twisted the relationship between asset prices and economic data can become. The report, for all intents and purposes, turned out to be a major disappointment. According to the US Labor Department the economy added 142,000 net new jobs during the month, far fewer than the 203,000 economists expected (there’s that lack of predictive ability again). Furthermore, the August and July jobs numbers were both revised lower as well. These results were widely hailed as being a let-down, and as Brad McMillan of the Commonwealth Financial Network put it, “a disappointment across the board…not what the markets were looking for”.
If this is true, why then did the stock market finish up by 1.5% the day the report came out? Because in the current confusing, chaotic state of affairs some bad news is actually viewed as good by Mr. Market. A negative jobs report like this one is seen as having a silver lining: the continuation of generationally low interest rates. Perhaps, as the thinking goes, the economy is slowing enough that Janet Yellen and her cohort at the US Federal Reserve will continue to delay their first rate hike and maintain zero interest rate policy just a little bit longer.
But ask yourselves…why would Mr. Market cheer on more accommodative monetary policy? Because low interest rates and the free flow of credit should, in theory, lead to stronger economic activity. And what is one of the primary measures of economic health and vitality? JOBS. In other words, a weak labor report suggests the Fed will delay raising interest rates which should lead to…you guessed it, a stronger labor report in the future. And stocks go wild.
This dynamic is widely observed and is displayed in the chart below showing that, on average, when the economy is in expansion mode the stock market tends to like it when the jobs report disappoints due to the expectation of marginally more accommodative policy. Interestingly, when the economy is in contraction mode the relationship between jobs data and stock prices seems a bit more straightforward. Stronger than expected jobs indicate the recession may be ending, and risk assets rally in anticipation of the next upturn in the economic cycle. We are currently in expansion mode, so the stock market’s performance in response to the last labor report seems to be in line with recent trends.
Even though this dynamic is well documented, it’s still not simple to predict. Who knows if it will break down in the future, especially given the fact that once something like this is known market participants begin trying to anticipate it and thereby disrupt the historical patterns. Furthermore, the Fed is experiencing a significant amount of internal confusion over how to interpret the economic tea leaves and what they mean for future policy decisions. There are several open market committee members who believe they should have begun hiking rates already and many who think they should delay well into 2016. Minneapolis Federal Reserve President Narayana Kocherlakota even advocates for implementing negative interest rates! If the paid professionals can’t seem to agree on what it all means, how should the rest of the citizenry be expected to?
If all of this leaves you feeling a bit mystified no one would blame you. In fact, recognizing some level of confusion over the interplay between economic data and financial markets is a sign that you understand its complexity better than most. This is yet another reason why we believe having a detailed financial plan and a well-defined portfolio management discipline in place is so important. Doing so relieves the pressure of having to predict the future and bases outcomes more on the consistent execution of financial habits that promise to pay off over time. We believe this is a better approach than attempting to outsmart the economy and financial markets at every turn. After all, in chaotic times like these maybe we’re all just a little bit confused.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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