By contrast, investors in Russell 2000^® small-cap companies appear to see a murkier picture where smaller-sized enterprises are struggling and the economy is beginning to lose jobs at a rapid clip.

Since hitting its all-time high in 2021, the Russell 2000 has underperformed 3-month T-Bills by nearly 20%, while large cap stocks have kept pace (Figure 2). Gold, which normally reacts negatively to the notion of higher rates for a prolonged period of time, has reached new highs.

It’s almost as though fixed income and large-cap investors are being guided by a set of different numbers than those in small caps and gold. Indeed, they might be. Both the employment and inflation reports contain numerous data series – many pointing in opposite directions.

Based on the two leading jobs reports from the Department of Labor, over the past three months, the U.S. economy added over 700,000 jobs, or it lost nearly 1.5 million. 

The establishment survey, which collects data mainly from large and mid-sized firms, has shown strong growth in non-farm payrolls over the past three months, with 708,000 jobs created since the beginning of December. That expansion is in line with the rate of job creation between 2010 and 2019 and shows a healthy U.S. labor market.

Conversely, the household survey has shown a loss of 1.474 million jobs in the same period (Figure 3). By collecting information from 60,000 Americans each month, it is less focused on larger employers. Its measure of job creation underperformed that of the establishment survey during the 1990s as well, which was another period when small cap stocks trailed large caps. 

Different borrowing costs might be a cause for such contradictory situations today. While many large companies locked in inexpensive long-term financing by issuing bonds in 2020 and 2021 when yields were at historic lows, smaller firms mostly borrowed from banks. Since then, interest rates have risen by 500 basis points or more. Additionally, many large firms have cash piles earning 5% per year just by sitting in short-term securities.

Turning to inflation, very different conclusions can be drawn depending on how much weight investors give to owners’ equivalent rent, a key component of the U.S. CPI. The headline rate includes it. When core inflation surprised expectations on the high side in March at 3.8%, the market fell into line with the Fed’s outlook on rate-cut expectations.

However, most of the persistence in inflation comes from owners’ equivalent rent, which assumes that homeowners rent their own properties from themselves. This has been rising at 6% per year and represents about one quarter of core CPI. Excluding it, as is the norm in Europe, would mean that U.S. CPI is running at 1.9% rather than 3.2%. This implies core inflation of around 2.5%, not far from pre-pandemic norms. It suggests that the Fed has real rates at around 3%, close to where they were in the 18 months before the financial crisis.

Has the Fed overreacted and overtightened monetary policy by focusing too much on core inflation numbers? The bond market doesn’t think so. It is pricing a gradual reduction in Fed rates to 3.75% from the current 5.25%-5.50%. By contrast, gold investors may be banking on much deeper rate cuts. Though it typically reacts negatively at prospects of higher rates, gold’s recent rally to record highs could be a sign that investors expect the Fed to cut more deeply in the future.

Investors parsing U.S. economic data are managing their risk outlook from a range of scenarios. An overheating economy with persistent inflation. A goldilocks scenario with strong employment and low inflation. 1970s style stagflation. Or the early stages of a classic recession. Ultimately, one scenario is likely to prevail. But, for the moment, one can look at the numbers and reach almost any conclusion.