Maybe it is a healthy correction

Good morning. A terrible Michigan consumer sentiment survey landed Friday morning, showing unease about the economy for households across income levels. But the market rose strongly all the same, as it became clear the US government would not shut down. Are you jumping back in? Or fading the rally? Email us: robert.armstrong@ft.com and aiden.reiter@ft.com. 

Stocks: the first shall be last

Since the stock market turned south about a month ago, there has been a remarkable reversal in which stocks are performing relatively well and which are performing relatively badly. 

The fifty worst performing stocks in the S&P 500 since February 19 have an average total return of negative 22 per cent (that’s an equal-weighted average, not capital-weighted, so it does not just capture the moves in a few huge stocks). Those same fifty stocks performed incredibly well in the preceding rally, which started in October of 2023 and ended last month: they returned, on average, 103 per cent over that period. 

Meanwhile, the fifty best performing stocks in the S&P over the past month are up, on average, 11 per cent. That’s a bit more than the 9 per cent those same stocks returned over the course of the last rally.

Below the point is represented graphically. The light blue columns represent the stocks that have done well in the past month; the big losers are in dark blue. Yesterday’s winners are getting an absolute hiding while the stocks that merely chugged along in the last rally have done just fine. 

What this suggests to Unhedged is that what we are seeing is not so much a panicky sell-off of risk in all its forms as investors locking in profits where they have made huge gains. 

Every sell-off is a reversal in market leadership, to a greater or lesser degree, as investors sell growth and cyclicality and buy steadiness and defensiveness. And it is true that the worst-performing stocks in the last month are heavily tilted to consumer discretionary stocks, while the best performing tilt towards healthcare, staples, insurance, and defence stocks. But the shift is more violent than, for example, the 2022 reversal. Perhaps this is because the last rally was so narrowly concentrated in information technology, which has performed abysmally in the past month.

These observations are admittedly anecdotal rather than scientific. But so long as the sell-off looks to be dominated by profit-taking in stocks that have run up wildly in the past few years, it can plausibly be called a healthy correction in what was (and mostly remains) quite an expensive market. If the sell-off continues and widens, on the other hand, it will look more like a general flight from risk — a bear market. 

The dollar: stuck between lower growth and higher inflation

The dollar has fallen hard since its big run-up prior to and immediately following the presidential election. In the first week of March, it took a pretty big stumble over fears of a US slowdown:

But, interestingly, the dollar was more or less flat during last week’s equity market chaos. This, on its face, is curious — last week’s market fall seems to have been mostly from concerns over weakening economic growth, which, all else equal, would drag the dollar lower. It did fall on Monday, but the dollar finished the week close to where it started:

The dollar’s rise around the election, like the equity rally, reflected expectations that Trump’s policies would boost both growth and inflation. That narrative turns out to have been overstated. At the end of last year, the Fed signalled a pause in its cutting cycle, while other central banks looked set to continue lowering their own rates, suggesting that the rate differential between the US and other countries would stay wide, supporting the greenback. We also got a couple of hot economic readings, suggesting that the Fed might even raise rates. Fourth quarter GDP was robust. The inflation readings in November, December, and January were sideways-to-up. The dollar hit its highest level after a particularly strong January jobs report — not when Trump was elected in November or announced tariffs later in January.

The fall earlier this month was in part due to investors’ losing hope in seeing growth-friendly Trump policies, but it was also investors dialling back growth expectations as the data cooled. There was an external factor, too: the Euro surged, following a shift in fiscal policy from Berlin.

Last week’s dollar tranquillity, relative to stormy equities, might show that it is a more sensitive and timely gauge of tariff policy. Currency markets have reflected tariff uncertainty more quickly than equity markets since the inauguration. Last week’s stock market fall could have been equities catching up with the dollar’s earlier weakness, on expectations of a US slowdown.

But last week’s relative calm could just reflect that recent data has been a wash for the dollar. Currently, the market is not just fretting over weaker US growth — it is fretting over higher prices and, perhaps, stagflation. While slowdown fears do suggest a weaker dollar, hotter inflation suggests a stronger greenback. We are still waiting on harder evidence of a slowdown. And the inflation data we received last week was inconclusive. CPI and PPI came in cooler than expected, suggesting a weaker dollar. But both measures also signalled that PCE — the inflation measure favoured by the Fed — could be hotter later this month. Fixed income markets were more or less static last week, as bond traders waited for CPI/PPI data, which naturally restrained the dollar. Fixed income markets may be muted going forward, too, as investors wait for PCE to judge the direction of inflation.

It’s tempting to argue that the dollar did not fall alongside equities because of the “dollar smile” — the tendency of the dollar to strengthen in times of market duress. But, as James Reilly at Capital Economics points out, that does not seem to be the case; other safe haven currencies, particularly the Swiss franc and the Japanese yen, did not rally last week, suggesting there has not been a flight to stable currencies.

Until we get stronger evidence of a slowdown or a better indication of where inflation is headed, we might see a flat dollar, despite potential volatility in equity markets. Other currencies, however, are still moving around tariff fears. Both the Canadian dollar and the Mexican peso gained against the US dollar last week. The Canadian dollar is now trading around where it started before Trump announced tariffs on Canada, and the Mexican peso has strengthened:

This might reflect relative optimism for Mexico’s outlook, as it seems that Trump is more set on punishing Canada. But it’s hard to draw any real conclusions — no one knows what Trump will do. Currencies have been the best gauges of tariff policies so far this year. Yet, with so much back and forth over the past three weeks, maybe that is no longer the case.

(Reiter)

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A choice.

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