Markets Brief: Beware the Melt-Up as Investors Ignore the Economic Gloom

Emerging Markets Rise as Dollar Falls

The US government shutdown was greeted with equanimity by investors, who seem to agree with Morningstar senior US economist Preston Caldwell’s view that its economic impact is likely to be negligible. However, it’s worth noting that the Morningstar US Market Index was a relative laggard among global stock markets last week, while developed markets outside the United States rose 2.6%.

The sentiment among emerging-market investors was even stronger, with the index up 3.4%, driven by China, which gained 4.0% over the week and 41.6% over the year to date. Following a pattern that has become familiar to investors this year, these returns were boosted by a decline in the US dollar.

Healthcare Stocks Lead the Gains

Despite the overall rise in the market, the outcome was mixed at a sector level, with five of the 11 stock sectors falling over the week. In contrast with recent market trends, healthcare stocks led the gains, rising 6.6%. This dramatic turnaround appears to reflect greater optimism about a resolution in the pricing dispute between the Trump administration and healthcare companies following an agreement with Pfizer. These stocks now no longer appear significantly undervalued.

Meta and Netflix Down

In contrast, communication services fell 2.2% driven by Meta Platforms META, down 4.5%, and Netflix NFLX, down 4.7%. Absent news to rationalize these movements, they are a useful reminder that stock price can move independently of changes in the fundamental characteristics of a business or obvious sentiment drivers. One of the reasons investing is always long term is that these fluctuations tend to even out over time, and so returns tend to reflect the fundamental characteristics of the business, plus or minus any gains from the reversion of the current price/fair value ratio.

Jobs Data Hit by Government Shutdown

One immediate effect of the government shutdown is the absence of key economic data, which reduced the monthly “Jobs Friday” to merely another Friday last week. While unsettling to commentators, this lets us speculate on the outcome and its impact on investors.

There are three potential results for any data release: The data is stronger than, weaker than, or in line with expectations. While in-line outcomes are typically ignored, stronger or weaker outcomes can move asset prices, as the release either reinforces or challenges the dominant narrative. Reinforcing data generally moves asset prices in line with recent trends, while challenging data can result in a pause or even reversal of trends as commentators adjust their narratives.

We know that most economic data has little impact on the fair value of securities, and price movements resulting from that data are mostly noise that increases the likelihood that we make poor decisions. Absent the jobs data on Friday, investors lacked a new narrative, and fewer were driven to make decisions that could disrupt their longer-term investing success. It is worth remembering this when the shutdown ends and data starts flowing again.

Trump Job Threats

Although the broader impact of the shutdown is likely to be minimal, President Donald Trump’s threat of permanent job losses increases the probability of a longer-term impact. As the downside risk to the economy has grown, investors have become more confident of two further interest rate cuts before the end of the year.

Look Out for the Stock Market Melt-Up

The fact that equity prices have rallied as economic risks have grown suggests that we may be entering the “all news is good news” part of the market cycle, when each announcement is received positively, as either a sign of an improving economy, or a greater incentive for the Fed to cut interest rates. Such periods are typically associated with a “melt-up” in equity prices, which seem to rise continually from already-unattractive valuations.

These periods are dangerous for investors, as they inspire fear of missing out and can lead to investors committing too much capital at unusually high valuations, which can ultimately lead to greater pain when valuations decline. The most recent example of this was in 2021, when US equities rose 24.1% and were consistently trading around fair value, before declining by 20.7% and falling to a 22.5% discount to fair value by the end of September 2022. Morningstar’s Dave Sekera addresses the challenges posed by the current high valuations in his fourth-quarter market outlook.

Federal Reserve Minutes Due

Although the few economic releases scheduled for this week will be delayed, unless the shutdown is ended, the Fed will release the minutes of the last Federal Open Market Committee meeting on Wednesday. This will provide more information about the data supporting the decision to cut rates, which may influence expectations for further rate cuts this year. If other data is released, you’ll find it on this calendar.