Why bad news for the economy can be good news for stocks

• Strange market logic shows why good news for the economy can be bad news for stocks.
• Some investors want to see growth and employment falter so the Fed cuts interest rates.
• But a healthy economy is good for stocks over time as it fuels spending, hiring, and investing.

Good news for the economy can be bad news for stocks, thanks to a weird quirk of market logic.

Positive economic developments such as strong GDP growth, robust employment gains, and mild inflation tend to drive stocks higher in the long run. Yet their implications for interest rates have mattered more to stocks in recent months. Here's why.

How stocks and the economy are related

The performance of the stock market and the economy are correlated over the long term, as a company's stock represents the projected value of its future cash flows, which are closely linked to the economy's growth and stability.

When an economy grows, it usually means jobs are being created, household incomes are rising, companies' sales and profits are swelling, and consumers and investors are feeling confident instead of stressing about being laid off or a recession taking hold. All of that tends to push up stock prices.

Similarly, low and stable inflation boosts confidence among consumers, businesses, and investors. That buoys stocks by fueling spending across the economy and demand for risk assets.

Low unemployment makes it more expensive and laborious for employers to find workers. But it also signals that companies aren't struggling so much that they're laying off workers in droves. Moreover, it means many consumers are earning regular paychecks they can use to buy goods and services from businesses, which contributes to corporate bottom lines and stock prices.

By that logic, months of economic data showing inflation returning to target levels, unemployment remaining near 40-year lows, and steadily rising GDP should hearten investors and lift stocks, especially as it makes an imminent recession less likely.

Yet Wall Street hasn't welcomed the news for one big reason: the Federal Reserve. The central bank hiked interest rates from nearly zero to north of 5% and has kept them there as it works out how to bring inflation down to its 2% target.

Rate pain

Those rate increases have heaped pressure on stocks by discouraging spending, hiring, and investing. Many households face not just painful rises in their food and fuel bills and rents, but also larger monthly payments on their mortgages, cars, and credit cards since the Fed raised borrowing costs.

Businesses have seen their interest expenses rise, dealing heavy blows to debt-reliant sectors like commercial real estate and the regional banks that primarily fund them.

As for investors, they've rushed to capture the larger yields offered by government bonds and savings accounts. That has reduced the relative appeal of stocks, which typically generate better returns but carry greater risk.

Increased pressure on consumers, businesses, and stocks represents a triple headwind for stockholders. It's little wonder they're rubbing their hands in anticipation of the Fed starting to reverse its hikes this year now that inflation has stayed below 4% for several months.

Fed dilemma

However, Fed Chair Jerome Powell and his colleagues won't start cutting until they're confident that inflation is under control and they won't reignite it by stimulating the economy. They may decide a recession is looming large and it's worth slashing rates to reduce its length and severity.

The result is that economic data showing strong consumer spending, healthy job growth, and fast-advancing GDP threaten to stoke inflation fears, settle recession worries, and thus push back the Fed's timeline.

The strange consequence is that good news for the economy is being received as bad news on Wall Street, because it dashes hopes of an imminent cut to rates and a bump to stocks, and increases the chances that the Fed might hike further.

Good news on GDP data "has the potential to be bad news for market sentiment, provided that strong growth and higher inflation would push the Fed rate cut expectations further down the road," Ipek Ozkardeskaya, a senior analyst at Swissquote Bank, said in a recent note.

Careful what you wish for

Of course, there's a risk to celebrating bad news as too much could herald a recession that the Fed can't stop, and recessions are reliably terrible for stocks.

The US could also suffer stagflation, where growth stalls but inflation remains stubbornly high, or even deflation and a dramatic spike in unemployment that tanks markets and shocks the financial system. Economic hardship generally dampens consumer spending and craters investor confidence, weighing on stocks.

It's bizarre that some stock investors are now hoping for the economy to soften so the Fed will start cutting rates, even though a booming economy is good news for stocks.

The reality is they want both a buoyant economy and much lower rates, and believe some pain now is the best way to get there. They should be careful what they wish for.