The Burden Of Managing Market Expectations

There is a guiding principle to market behavior that rises above fundamentals, above macro data, above central bank activity. It is the management of expectations that hold sway in the market.

Let's imagine that an important macro data point is due to come out. Let’s say that a number above 57 is good, but that the market expects the number to be 60. In the end, the data release shows 58.

The data itself is good because it beat 57. But since it missed the market’s expectation of 60, the market reacts, and that reaction is almost always an immediate drop.

I say all this because the markets, after the publication of the latest inflation data in the United States, began to convince itself and even price in the idea that the Federal Reserve, at its next meeting in September, would lift its foot off the accelerator and raise interest rates less (50 basis points instead of the recent 75 bps raises) and that in 2023 it would surely stop raising rates at some point, instead pivoting.

But reality is stubborn. At his Jackson Hole talk, Fed Chairman Jerome Powell reiterated that the goal is to control inflation no matter what, and that in his opinion households and businesses will suffer “some pain” in the fight against inflation, leading analysts to expect a 75 basis point hike in September (unless there comes a radical change in inflation in the weeks prior to the Fed meeting).

Cleveland Fed President Loretta Mester said she even favors raising interest rates above 4% early next year and keeping them there to curb price pressures. Moreover, she has acknowledged that the Fed got it wrong and that they should have started raising interest rates earlier.

The U.S. non-farm payrolls report came in above expectations at 315,000 jobs, above expectations of 300,000 jobs in August, bolstering the case for more aggressive rate hikes. The latest data also showed that job openings rose in July and consumer confidence rebounded significantly in August.

As for the European Central Bank, some are proposing a 75-point interest rate hike at its September 8 meeting. With energy priced in dollars, a weak euro makes it more expensive for the eurozone countries, adding inflationary pressure. A tighter monetary policy through aggressively raising interest rates is the path to strengthening the EUR/USD and combating this element of inflation.

Which is important, as inflation in the eurozone accelerated to 9.1% in August from 8.9% in July and broke a new record. Excluding energy, inflation rose to 5.8% from the previous 5.4%. And in Italy it rose to 8.4% in August, the highest in more than 36 years, rebounding from 7.9% the previous month.

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It is these two related factors that have wrongfooted the market, hence the recent falls.

Thus, under "normal" conditions, September could be another delicate month.

It’s also worth remembering that on a historical basis, September is the worst month of the year for S&P 500 performance in terms of investment returns, both average return and frequency of positive returns. Over the last 20 years the average return is -1.18%, over the last 50 years -0.92%, and over the last 100 years -1.08%.

For all this, there was a sign last Friday that investors haven’t lost complete control of their emotions. While the S&P 500 fell more than -3%, the VIX volatility Index remained near 25, i.e. below levels it reached when the S&P 500 suffered similar declines this year.