The stock market’s change in tune may signal a recession is in store.
For the last couple of years, Wall Street has graded the state of the economy on a seemingly counterintuitive rubric. In the wake of rampant inflation, which soared to a 40-year high of 9.1% in June 2022 due to increased fiscal spending, near-zero interest rates, supply chain shortages, and tight labor market conditions, weak economic data has been welcomed with open arms by the U.S. stock market. While the average Joe would decry an uptick in unemployment or a twofold increase in initial jobless claims, investors were rewarding it.
Why is that?
It all comes back to the Federal Reserve, who began hiking rates in March 2022 to combat inflation. The game plan was standard practice, à la former Fed Chair Paul Volker in the 1980s: make it harder for consumers and corporations to borrow money, thereby slowing the circulation of cash and rate of spending. This marked a stark departure from the era of free money in the early years of the COVID-19 pandemic, where companies faced few hurdles when trying to secure capital, regardless of how unhealthy their balance sheets or lofty their goals were. By July 2023, the Fed had raised rates 11 times, bringing them to a 23-year high and marking the fastest pace of rate hikes since Volker’s tenure.
While higher rates were perhaps just what the doctor ordered to cure inflation, they have been a tougher pill for the stock market to swallow. Rate increases have taken the biggest toll on companies with high valuations, especially growth-oriented technology stocks that benefited the most from low interest rates. There are a few reasons for this: 1) riskier assets become less attractive in higher rate scenarios because investors can find more attractive yields in classes like bonds; 2) the amount of cash that capital-intensive growth stocks are expected to retain is often reduced, as higher rates impact borrowing costs, thus decreasing profit margins; 3) securing low-cost debt becomes more difficult, making companies even more reliant on public market returns; and 4) if the rate increases do in fact work in the Fed’s favor and lower inflation, growth will also likely slow, wherein defensive stocks (think sectors that provide essential goods and services) will outperform, as they are typically less affected by economic downturns.
Within this more restrictive environment, much of the conversation on Wall Street over the last year has asked: “when is enough enough?” When will the Fed stop raising rates, thereby relieving pressure on corporations and consumers? When will inflation be at a secure enough place that people will not have to worry about it ticking back up again? Are rate cuts even on the table yet?
Investors have reviewed economic data with a fine-tooth comb, searching for evidence that the Fed’s job is near-complete. Employment reports have faced the most scrutiny because any print that shows job additions, lower unemployment, or wage increases on a monthly basis means consumers have more power to spend. The resulting uptick in economic activity then threatens the Fed’s work against inflation, which could incentivize officials to keep rates higher for longer.
And that is precisely why, up until recently, bad news on the economy has been cheered on by investors. When the number of new jobs added in April 2024 totaled 175,000, below the Street-estimated 240,000, the Dow Jones Industrials, S&P 500, and Nasdaq Composite surged between 1.3% and 2.1%. On the flip side, stocks fell on the heels of the January 2023 jobs report, wherein payrolls increased by 517,000, blowing past the consensus expectation of 187,000. One might think that most people would welcome signs of a robust job market, but for investors, this just meant the Fed had more work to do. As such, a clear trend — as paradoxical and backwards it may seem — was beginning to emerge: bad news on the economy was good news for stocks, and vice versa.
Since the Fed began raising rates more than two years ago, there has been considerable progress towards its 2% inflation target. July’s Consumer Price Index (CPI) showed inflation of 2.9%, the lowest level since March 2021. Higher housing costs remain the stickiest part of inflation, accounting for 90% of the year-over-year increase, while food prices continue to trend down. Gas prices were unchanged during July, though J.P. Morgan warns energy is historically the most volatile component of CPI’s basket of goods.
But at a headline inflation level, mission accomplished, right? Well, not exactly.
It seems the paradox has reversed. Bad news is no longer good news: bad news is simply bad news once again. And the shift in sentiment has been nothing subtle.
Weak economic reports that would have pleased investors just a few months ago are now being punished. Key manufacturing data dropped to an eight-month low in July, signaling a slowdown in consumer spending and industrial activity. Stocks sold off in response, as investors feared the economy may not be as strong as it appears.
Then came the July employment report — the former poster child for bad-news-is-good-news — where job growth came in at 114,000, below the 185,000 estimate. The more concerning figure, however, was the unemployment rate of 4.3%, its highest level since October 2021. In response, investors referenced the so-called Sahm Rule, which says an economy has entered a recession once the three-month moving average of the unemployment rate is at least half a percentage point higher than the 12-month low. Not surprisingly, stocks plunged, with the Dow posting its worst day in nearly two years on August 5th. Volatility moved in the opposite direction, spiking as investors rapidly sold in and out of positions to protect their portfolios.
The sell-off extended beyond the U.S. to other major markets, including Japan, which suffered its worst single-day drop since Wall Street’s Black Monday in 1987. Adding fuel to the fire was an unwinding of the yen carry trade — a.k.a., selling the Japanese yen to fund the purchase of higher-yielding currencies or other assets — after the Bank of Japan ended its historic regime of negative interest rates earlier this year and raised rates this summer. More proof that bad news is now just bad news.
“If data were to decline materially, the market would price even more rate cuts. It definitely causes volatility because it’s really connected to these levered positions that are out there,” says Ben Emons of FedWatch Advisors. “I would look at leading indicators in particular.”
A 1% increase in retail sales during July, paired with a decline in weekly jobless claims, returned some hope to investors, but lingering concerns still remain. Goldman Sachs is now forecasting a 20% chance of a recession this year, up from 15% prior to the July jobs report, while J.P. Morgan says there is a 35% probability, compared to the previous 20%. Retailers like Home Depot are cutting their sales outlooks as consumers spend less on home improvement projects due to higher rates and economic unease. The once thriving experiences sector, fueled by the post-pandemic travel boom, is also warning of a slowdown. Disney says the lower-income consumer is facing more stress than before, which is weighing on theme park traffic. Even fast-food chains and packaged goods companies like McDonald’s, Starbucks, and PepsiCo are reporting sales declines as household saving reserves dry up.
So what comes next? With stocks already returning to the levels they saw before the massive August 5th sell-off, were recessionary concerns overblown?
“The good news is that good news is good news now,” says Emons, who is keeping a close eye on the Fed’s next move.
What the central bank does at its September meeting will likely have a major impact on the markets. It is all but certain that the Fed will lower rates, according to the CME FedWatch Tool, but whether that means 25 or 50 basis points remains to be seen. Economic data almost always lags current conditions, so the question is whether there is more bad news (which, remember, is now just bad news) to come. If so, are rate cuts in September enough to save the economy from dipping, even briefly, into a recession?
As one Wall Street insider told me, those complaining about inflation may soon realize that higher egg prices are far better than not having a job at all. The paradox of bad-news-is-good-news may finally be over, but perhaps rooting for warning signs in the first place led to more trouble than they were worth to begin with.
Michelle Yu (MBA ‘26) is passionate about all things media, with experience in business news, documentary film, broadcast journalism, and television. She graduated from Columbia University with a degree in Film and Media Studies and was a producer for CNBC prior to HBS.
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