Weak economic data lift financial-market valuations when inflation is controlled

What's this about?

People disagree about whether bad economic news can raise market prices when inflation stays low.

This may happen if investors expect lower rates, but weak news can also hurt firms.

What supporters say

• When inflation stays low, a central bank can cut rates if the economy slows.
• Surprise news can change guesses about rates and move markets around the world.
• Lower expected rates can make future company money worth more today.
• Markets may see weak job news as a sign that leaders will cut rates.

What critics say

• Investors may care more about rising prices, which can keep rates high when growth slows.
• Rate news also tells people about jobs, growth, and risks, not just borrowing costs.
• This link can change during booms, slow times, and market crashes.
• Weak data can make investors fear that firms will earn less money later.

How to read this

The number of points on each side does not show who is right; strong proof matters more than a long list.

The bottom line

The claim can happen, but only in some cases.

The evidence supports it most when inflation stays low and rate cuts seem more likely than lower profits.

The claim is that weak economic news can lift financial-market valuations when inflation is under control, because investors may expect lower interest rates. But the effect depends on whether markets focus more on easier policy or on weaker profits and recession risk.

The case for

The strongest support comes from a conditional interest-rate channel. When economic activity weakens, investors may expect central banks to cut rates. Lower expected rates reduce the discount applied to future company earnings, which can raise the present value of stocks and other assets. Research on unemployment announcements found that rising unemployment sometimes lifted share prices during economic expansions, apparently because investors saw it as a sign that rates would stay lower. 1 (see Figure 3)

This does not mean that markets ignore earnings. Monetary policy can affect equities through several routes at once, including interest rates, expected cash flows and risk premiums. A weak economic release can therefore lift valuations when its effect on expected rates is stronger than its effect on expected profits. 2 (see Figure 2)

Controlled inflation is an important condition. If inflation is subdued, a central bank has more room to respond to weaker growth with rate cuts instead of further tightening. BIS analyses find that inflation surprises can push expected policy rates higher and weigh on stocks, while weaker growth combined with falling inflation can lead markets to price larger rate cuts. 3 (see Figure 1)

The effect can also spread beyond the country where the data are released. High-frequency studies covering stock indexes in 27 countries found that U.S. economic news moves global markets. Releases that differ from expectations can cause investors to revise their views of future interest rates, particularly after labor-market and inflation data. 4 (see Figure 4) The relevant issue, then, is not simply whether an indicator is weak, but whether it is weaker than investors expected.

The case against

Weak data can also signal lower future earnings and a higher risk of recession. That message may overwhelm any benefit from lower expected rates. Studies of unemployment news found that bad labor-market reports tended to push stocks down during contractions, when investors were more concerned about falling corporate cash flow and recession. 5 (see Figure 3)

The relationship therefore changes across the business cycle. Rising unemployment was associated with positive stock-market reactions mainly during expansions and negative reactions during contractions. Controlled inflation alone cannot guarantee that weak data will raise valuations. 6

There is also a problem in interpreting policy news. A central-bank announcement may contain information about officials’ assessment of the economy, not just a change in interest rates. Research on monetary-policy surprises finds that asset prices respond both to unexpected policy moves and to signals from the central bank about the economic outlook. Adjusting for the central bank’s response to earlier news can weaken the idea that easier expected policy has a one-way effect on markets. 7 (see Figure 4)

Finally, inflation may remain the market’s main concern even when growth is weakening. Positive inflation news can raise expected rates and depress stocks, reducing the central bank’s ability to cushion weak growth. “Controlled” inflation must therefore mean more than inflation that is merely not accelerating sharply. 8 (see Figure 1)

The bottom line

The evidence supports the claim as a conditional mechanism, with fairly strong confidence, but not as a general rule. Weak economic data are most likely to lift valuations when the economy is still expanding, inflation is subdued, investors had expected tighter policy, and the news does not sharply worsen profit or credit expectations.

The claim becomes much less reliable when weak data point to recession, falling earnings or financial stress, or when inflation limits the prospect of rate cuts. The central uncertainty is that one release can change expectations about rates, profits, inflation, recession risk and risk premiums at the same time. The evidence supports the rate-cut channel, but it does not show that this effect has the same size across all markets, economic conditions or asset classes.