2022 Theme: Financial Conditions Update - Higher & Higher = Watch Out
If US stock markets are rising in the teeth of negative news, then it is probably time for an update on US financial conditions and reminder as to why they are so critical.
Again and again this publication has argued that following financial conditions is the key to understand:
The direction of the economy over the long term.
The direction of the stock market over the short term.
Financial conditions often acts as a reliable lead for both and especially the latter because tightening (or higher) financial conditions are typically associated with less credit available and more expensive rates for what does exist.
Financial conditions are the ultimate tail that wags the dog.
Helpfully, Goldman Sachs puts together a great financial conditions index that combines many of the different short term indicators that make up US financial indicators. It isn't perfect (no index is perfectly representative) but it is very useful and highly predictive of changes in Real GDP.
Strikingly, last week, the Federal Reserve finally raised interest rates and yet the GS Financial Conditions index eased - slightly - by .375.
See here:
(this graph is hard to interpret but the index fell from well over 98 to just below that level at 97.92)
Therefore, falling or loosening financial conditions might be one hint for why the stock market continues to be so buoyant but why did they become looser/lower this past week then?
At first blush, this seems counterintuitive. As we have covered in depth, rates are rising around the globe. Jay Powell is talking tough about potentially doing far more (see below). What gives?
Well, the answer might have more to do with fears of contagion around Ukraine and the end of spiking in commodity markets than it did with a well telegraphed 0.25% interest rate rise.
So, the Fed increased the discount rate and promised to do more and US interest rates rose accordingly but:
Other data confirmed that the US economy continues to be in rude health. To give just one example, 187,000 americans filed for unemployment benefits last week - the lowest weekly number since 1969.
Most importantly credit spreads eased as fears about Ukraine war spreading elsewhere diminished and equally important, concerns around financial issues stemming from sanctions on Russia also eased.
The latter is a particularly strong reason.
There were - and still are - concerns that excising Russia entirely from the global financial system could unleash some very unpleasant unintended consequences. This could be a 2008-type error (or perhaps a more minor even such as the 1998 Long Term Capital Management collapse).
Diminishing fears around that possibility have been a huge boost for global growth and risk assets.
Why does this matter?
It matters because it may explain why stock markets continue to rally despite a war, high inflation and central banks hiking interest rates and tightening credit conditions around the globe.
The rise in stock prices has less to do with how great the world is at the moment and more to do with relief that some very bad scenarios are looking less likely. 2008 financial contagion in the banking system or a series of state defaults in 1998 would be much, much worse.
And make no mistake, conditions easing for a week or two does nothing to change the long running theme of tighter credit markets and eventually less liquidity from central banks.
It also does nothing to remove the scarily high probability of a Fed "mistake" (see below) going forward.
So, this last few weeks have been both welcome and perhaps strange but:
Do not be fooled.
This bounce is a great opportunity to lighten up on risky sectors or assets and also prepare for the dramatically different and uncertain world we are now entering.
This will be a world that will likely have less credit, higher costs, less interdependence and lower growth.
Hoping (or praying) that assets that have struggled severely this year will reach previous levels let alone make new highs is very unrealistic in this environment.
Take the bounce and run.
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