Why markets have the jitters

Markets are skittish. Tiny shifts in the economy are magnified into fear of recession or big relief rallies as sentiment swings wildly. Add in the deflation of some of the artificial-intelligence hype and recent stock moves frequently don’t seem to make much sense.

Yet, under the surface two themes are emerging. We have entered a new market paradigm with a focus on economic growth, rather than inflation. Connected with that, previously unloved stocks have beaten the market’s stars, helped by looming Federal Reserve rate cuts.

The big question for investors is whether these shifts will last.

“The market’s trying to estimate the path forward and exploring the potential for a regime shift,” says Sonja Laud, chief investment officer at Legal & General Investment Management. But, she says, “there’s clearly still a majority expecting a soft landing, and the data is supportive of that.”

The two new themes make a lot of sense. First, the change in focus to the health of the economy happened as inflation appeared to be under control while the jobs market weakened. The Fed has switched from worrying about too much growth to worrying about too little growth, and recession probabilities have picked up—albeit from very low levels.

“Six months ago we had a zero risk of recession,” says Johanna Kyrklund, chief investment officer at Schroders. Now there is a risk, she says, that weakness among lower-income households starts to affect the rest of the economy.

The markets are far more sensitive to economic indicators than they have been in the past—because investors are aware of just how much rests on a soft landing.

This week, some slightly-weaker-than-expected manufacturing data led to another reassessment of the outlook, with stocks falling sharply and the 10-year Treasury yield dropping 0.08 percentage point. Moves of this scale in Treasurys have become common recently, but used to be reserved for major shocks; there was only one fall this big in the whole of 2018, for example.

The focus on economic weakness also shows up in a changed link between stocks and bonds. When the market focused on inflation, good news on the economy was generally bad news for stocks because it meant upward pressure on prices and higher interest rates from the Fed.

Now good news on the economy is good for stocks, because it relieves concern about growth, and rate cuts are expected anyway. The opposite also holds: Bad news on the economy is now bad for stocks.

As a result, the link between the S&P 500 and 10-year Treasury yields that held for a year has reversed. Stocks and bond yields have a slight tendency to rise and fall together, rather than moving in opposite directions, as they did previously.

Falling yields are part of the reason for the recovery in unloved stocks, the second theme. Since the Juneteenth holiday, when AI superstar Nvidia hit its last high, cheap “value” stocks have done far better than growth stocks. The Russell 1000 value index is up 5%, while its growth version is down 4%—although that has only partially reversed the stunning gains for growth earlier in the year. The average S&P stock has also handily beaten the index, after lagging far behind in the first half of the year.

The reverse also held for the best- and worst-performing sectors. Technology and communication services went from best to worst, while highly leveraged real estate went from worst to best thanks to falling Treasury yields.

However, the market’s story isn’t perfect. Banks did well in both periods, helped by the steeper yield curve as longer-dated bond yields fell less than shorter dated (the 10-year yield was briefly above the 2-year on Wednesday for the first time in two years). Utilities were helped by lower yields, but were boosted all year by a boom in electricity demand for AI processing. And boring consumer-staples stocks that are meant to do well in a weak economy beat the more-exciting consumer-discretionary sector in both periods.

Smaller companies are also failing to match the theme. They haven’t benefited from lower bond yields, even though they carry more debt. There has also been little difference in the performance of small growth and small value.

My guess is that the market will continue to be supersensitive to signs of economic weakness, even after the Fed starts cutting rates, as recession will remain a risk for a good while yet. I’m less sure about the return of value stocks. Aside from anything else, for more than a decade now, no value rebound has been sustained.

Write to James Mackintosh at james.mackintosh@wsj.com