For years, investors have been living in a “new normal” where bad economic news is good for stocks, and good economic news is terrible. This mindset took hold because weak economic data signals a lower chance of the Federal Reserve raising interest rates to combat inflation. On the flip side, strong economic data suggests that the Fed might need to raise rates to cool things down, potentially leading to a decline in stock prices.
However, the most recent economic data suggests we may be in for a U-turn on this thinking. This week, after months of highly concerning inflation reports, April’s consumer price index (CPI) showed a welcome decline. At the same time, softer retail sales figures suggest shoppers have put their wallets away. This is the slowing economy and declining inflation investors have been wanting to see.
And the news of a weakening economy keeps piling up.
First the Bad News
The details of the Retail Sales data for April are that it came in unchanged, contrary to economists’ forecast of 0.4% growth, indicating greater consumer caution than expected. This may be because of increased household worries over rampant price increases. These are all economic problems that the stock market still loves.
Adding to the pile of weak numbers, the Empire Manufacturing and NAHB housing index also came in weaker than expected. This was bullish for stocks as the outlook for the Fed to cut interest rates improved. The proof that we haven’t turned the corner yet on “bad news is good news” is that after these two weak economic reports were released, the S&P 500 (SPX), Dow Jones Industrials (DJIA), and Nasdaq 100 (NDX) all reached record highs.
This positive reaction in the stock market reflects a potential turning point for investors. The days of “bad news is good news” for stocks may now be numbered. In the near future, a weaker economy, coupled with easing inflation and potential Fed rate cuts, could once again translate to a more traditional market dynamic. A mindset where a weaker economy translates to a weaker stock market. This should be recognized in advance because investors should be prepared to adjust their strategies when it happens.
Now the Good News
While it very often points to a weakening economy, lower inflation is welcome by most markets, as long as it doesn’t fall below zero. And we’re a long way away from zero. So when headline inflation dipped to 3.4% in April, down from 3.5% in March, good news was good news.
Meanwhile, in the same set of data, Core CPI, excluding volatile food and energy prices, also showed a significant slowdown, rising 3.6% year-over-year compared to 3.8% the prior month.
A Shifting Mindset
The Fed’s focus is on inflation. The market’s focus is on the Fed’s determination to get inflation to 2%. If it appears the Fed is winning, and inflation takes less of a role in assessing key economic releases, then the world can return to normal. Good goes back to good, and bad gets its bad reputation back. Then we all welcome back the old norm as the new norm.
As investors, we have to be aware that this new period will come. We may soon get even closer to this shift in mindset if we see a lower Personal Consumption Expenditures Price Index (PCE) inflation number. This report is out on May 31st.
Inflation is the bug the Fed is trying to kill. If inflation looks like it is dying, the Fed can be expected to put the economic poison away.
Key Takeaway
Investors are acclimated to the bizarre situation where weak economic data is fuel for stock market rallies. This stemmed from the fear of rising interest rates to curb inflation. However, recent trends like softening inflation and consumer spending suggest a potential shift. If lower inflation reports continue, it will please the Fed, and the market may revert to its historical norm. Investors should be prepared to adjust their strategies accordingly and ditch the “bad news is good” mentality.
