When it comes to the economy and economic forces affecting markets, it’s always important to remember that everything is interconnected. Corporations don’t operate in isolation. Events have second- and third-order effects that change how markets move and investors react.
As I write this on April 11, we had inflation readings this week for March showing higher-than-expected inflation. Markets reacted poorly, with the DJIA dropping more than 400 points that day.[1] Not only are there direct effects of inflation on stock prices, such as the eroding purchasing power of future earnings, the report’s indirect effect contributed to reducing investor confidence in the three rate cuts that many expected before the three negative inflation reports.
Many investors like the prospect of rate cuts for a handful of reasons. I think the two primary reasons would be a reduction in the cost of borrowing and increased investment in financial assets. Reducing borrowing costs is not only a positive thing for many individuals that stimulates the economy, but it can also stimulate businesses to borrow and expand operations or improve equipment. Lower interest rates also lead many to invest in financial assets for increased returns over traditional savings accounts, CDs, etc. All this to say, there is a bit of a perceived positive feedback loop in terms of economic growth when borrowing is less expensive, with limiting factors being trade imbalance and inflation. That said, many other factors contribute to stimulating economic activity, like consumer confidence and global economic conditions, to name a few.
We don’t always know the second-and third-order effects on economic reports, Fed decisions, or political outcomes. I like to use many tools like the CME Fed Watch tool[2] to see market probabilities of things happening, but we should be distrustful of certainty. This Zen farmer parable always comes to mind when I start thinking I know what will happen due to an economic news article https://simplicable.com/en/maybe-so-maybe-not.[3] Market dynamics are complex, and prices reflect investors’ beliefs about future events, which are, of course, not always rational. As always, having a plan, thinking long-term, and seeking diversification is a solid way to serve your clients.
[1] Goldfarb, S. (2024, April 10). Hot inflation report derails case for fed June rate cut. WSJ. https://www.wsj.com/economy/inflation-march-cpi-report-interest-rate-239b7e5e
[2] CME FedWatch Tool. CME Group. (n.d.). https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
[3] Spacey, J. (2023, July 29). The Chinese farmer parable: Maybe so maybe not. Simplicable. https://simplicable.com/en/maybe-so-maybe-not
