This Week in the Mayonnaise Clinic: Growth Is Up; Why Are Stocks Down?

Plus: Dressing for the company tailgate, and does Josh still think Gavin Newsom is gross and embarrassing?

Dear readers,

Welcome to the Mayonnaise Clinic! On this day that we have learned GDP grew at a 4.9% annual rate in the third quarter, Greg wrote in with a timely question:

Do you have thoughts on why investors seem to be so unhappy with an economy where GDP is growing and inflation has come down substantially? I gather that the markets really don't like high interest rates, want to see bigger profits from leading sectors, and may not care much about low unemployment for its own sake. Still, I was surprised to see this morning that we got a 4.9% quarterly GDP report and markets were down — this following a few months now of poor market performance despite (as far as I can tell) not-so-poor economic data. Tech earnings have disappointed, but if that GDP number is remotely accurate, some businesses are doing pretty well, no? I thought maybe there was a simple explanation I was unaware of, but quick Googling led me to some analyst saying, “It's hard to square such sequentially good economic growth with such lackluster stock market performance." Do you have a better explanation?

I do think this is all about interest rates. The 10-year Treasury bond yield is close to 5%, up more than a percentage point this year. Everyone has noticed how the high-rate environment has made it expensive to get a mortgage. Less discussed is the negative effect on asset prices.

It’s simplest to start out by thinking about bonds. Bond yields and prices move inversely — if a company issues a $100 bond that yields 7%, and then rates rise so the prevailing interest rate for the company’s debt is now 8%, nobody is going to pay $100 for that 7% bond anymore. A buyer will demand a sufficiently large discount such that the yield-to-maturity on the bond reaches 8%. As such, rising interest rates are a mixed bag for bond investors — they make it possible to earn more by investing in bonds going forward, but they reduce the value of the bonds you already own.

Something similar happens with other kinds of income-producing investments: When the yield on a very safe investment (like a government bond) goes up, investors will demand greater returns on riskier types of investments, because if they can’t get better returns in exchange for risk, they might as well sell those risky assets and buy safe ones. This demand for higher returns across asset classes will put downward pressure on prices — if the income stream that an investment is going to produce is fixed, the only way to increase the percentage return is to reduce the price paid upfront.

Midjourney image generation for “chaotic stock exchange floor full of traders loudly clamoring for higher returns on investment, vaporwave”

Of course, the income stream associated with a stock is not fixed. If interest rates are rising due to forces that are also likely to raise future corporate profits — for example, if rates are going up because the economic outlook is strengthening and that’s creating strong demand for investment capital — then those forces will push stock prices up, perhaps more than offsetting the downward price pressure created by the higher-rate environment. But if rates are rising for reasons that are not especially bullish for profits — for example, because the Federal Reserve is expected to need to keep rates higher for longer to fight inflation and the worsening fiscal outlook means the government will be competing harder with firms and consumers to borrow money — we should expect stocks, like bonds, to fall as rates rise.

High rates are not killing the economic expansion, but they are a problem for the economy, and I don’t think our political conversation is anywhere close to catching up with that fact. Donald Trump says that, if he’s elected, he’ll press the Fed to cut rates, but rates are high for a reason — if he wins and gets his way on interest rates, he’s likely to set off another big spike in inflation.

To take pressure off rates without spiking inflation, we need a fiscal adjustment — some combination of tax increases and spending cuts, similar to the set of policies enacted under George H.W. Bush and Bill Clinton in the early 1990s that created the economic environment that made it possible for rates to decline gradually through the 1990s while the economy grew robustly. What those presidents did worked. Unfortunately, Bush paid a huge political price for it, as (initially) did Clinton. Then, we lived through two decades of economic slack in which deficits basically didn’t matter, and in which centrist political figures burned credibility by demanding fiscal adjustments when they weren’t needed — successfully obtaining an ill-timed one in 2011, which greatly exacerbated the Great Recession. Now, the political appetite to do anything remotely unpopular to cut the deficit is close to zero — and will likely remain so until voters start making the connection between high mortgage rates and the federal budget deficit. I think it’s going to take a few years before that link sets in.

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Mike sent this question in weeks ago, but I’ll answer it now that the House has a new speaker:

Can you help us understand why Democrats would vote to get rid of Kevin McCarthy when it's almost certainly the case that the person who replaces him will be more obstinate and less able/willing to work to find compromises? I understand that he's not the person they want as a leader (i.e., not a Democrat), but thinking strategically, how is opening up the floor to an unknown new speaker a better option?

As I wrote earlier, the mess of this past month has wrong-footed House Republicans along several dimensions, and it’s hard to see how Democrats could have decided to pass up the chance to do that. There are benefits already visible: Republicans are no longer led by a highly effective fundraiser, and Republican members from swing districts have now voted to elect someone with a long record of extreme statements on social views that are sure to make it into attack ads. Republicans are also led by an inexperienced leader who faces a steep learning curve. If experience matters at all, this should create advantages for Democrats in both dealmaking and campaigning.

And I still don’t believe there’s reason to think this episode has made it harder to enact spending bills.