Today’s Capital & Conflict comes from Eoin Treacy. Usually you’ll find Eoin’s work at Frontier Tech Investor, but in anticipation of Valentine’s Day, here’s Eoin’s take on what could make the recent market volatility come roaring back tomorrow…
It is said they don’t ring a bell at the market top and that is certainly true.
Topping out is a process and there is always going to be disagreement at major turning points because so much is at stake. If everyone agreed it was a top, then rather than being a turning point it would probably be a cause to buy rather than sell on purely contrarian terms.
Instead when a bull market peaks it’s always a cause for violent disagreement. It’s not until well after the ultimate peak that people are willing to admit the error of their ways.
Without clear evidence they are wrong, the bulls won’t want to believe that the good news is going to stop coming. At the same time the bears are just beginning to see their strategy work and are becoming a bit more emboldened.
Bull markets don’t end with a whimper either, they are usually dramatic affairs with big upticks in volatility, where the status quo is shaken to its roots and people begin to think anew about what the market is all about. Little wonder then that after last week people are beginning to look at alternative rationales for market action.
There is no one going to be ringing a bell on Wednesday but it is definitely a day when there is going to be a major news event that is going to shape how people view the outlook for both bonds and stocks. And no, I’m not talking about Valentine’s Day.
The US Consumer Price Index (CPI) will next be updated at 1.30pm UK time. It’s the most commonly quoted measure of inflation. When it was last updated in December it came in at 2.1% and there were rumblings of the end of the low inflation environment. Right now, the Bloomberg survey of economists is expecting a figure of 1.9% on Wednesday.
They are assuming inclement weather will have deterred people from going out to buy new cars, which would drag the inflation number down somewhat. The decline in oil prices over the last few weeks will also begin to be factored into the calculation, so the balance of probabilities is that the measure will be somewhat lower for January than December.
However, it is always good to remember that the market hates surprises and this is a figure that could prove highly disruptive or conversely act as a tailwind should it come in below expectations.
Right now, US ten-year Treasury yields are testing the levels they hit during the so-called taper tantrum of 2013, which is around 3%. Back then, the bond market was worried the Federal Reserve was being too enthusiastic about the economy and that it was too early to remove stimulus. That chastened the central bank and it slowed down its plans for removing extraordinary monetary largesse, kept its balance sheet static from early 2015 until late last year, and has only raised interest rates five times in 27 months.
In short, the bond market’s signal of disquiet back in 2013 succeeded in scaring the central bank into a glacial pace of stimulus removal. So, what’s different today?
Well it’s simple enough. First off, we are more than four years on from the taper tantrum and the economy has done nothing but expand in that time. In fact, this is one of the longest, albeit modest in magnitude, expansions in history. That is why the US’ decision to adopt a massive fiscal stimulus is the very definition of procyclical policy. Giving everyone a tax cut when the economy is close to record low unemployment and where the trend of participation is moving upwards is tantamount to inviting inflation.
In short, bonds, as fixed interest investment vehicles, are allergic to inflation. That is why everyone is antsy about the CPI figure on Wednesday. If inflation overshoots expectations we can expect bond prices to collapse and the ten-year yield will surge above 3%. That would confirm the end of one of the longest bull markets in history. So what, I hear you say.
Well if you’ve been watching the financial media at any time over the last couple of years, you’ll have heard that valuations are close to historically high levels. In fact, the only times the Shiller price/earnings ratio on Wall Street has been higher was in 1999. The only way that kind of multiple is remotely justifiable is because bond yields are so low. It’s a relative comparison. I can justify paying the high multiple on stocks because the yield on bonds is so low.
However, if the yield rises then it becomes more appealing to investors looking to lock in a fixed return and therefore stocks need to be cheaper to attract investors into the market. Since on average stocks are not cheap now, the only way they are going to get cheap is either prices have to come down or earnings have to surge.
The problem right now is that the stockmarket rallied very impressively over the last four months on the expectation that earnings are going to soar on the back of the Donald Trump tax cuts. The short volatility-led disintegration last week put paid to that rally for at least the next couple of months. If inflation stays muted then the worst we are in for is probably a ranging phase with heightened volatility relative to the extraordinarily inert levels seen since 2016. However, if inflation surprises on the upside then we are much more likely to see another down leg.
It’s only fair to tell you that I don’t think inflation is about to surprise on the upside just yet. Corporates are getting their tax cuts right away, but what most people don’t get is that regular citizens will need to wait until they report 2018 taxes next year before they get the full benefit of the tax cuts. There is likely to be an uptick in consumer sentiment anyway, but the full effect of the tax cuts will probably not kick in until next year. Nevertheless, it’s an uncertainty that has a very well-defined date and therefore expect some volatility over the next couple of days as investors position themselves for the announcement and possible surprise.
Here’s something else to chew on. If we do not get a negative surprise then the market has the potential to rally. Millions of Americans are about to start getting paid. You see the vast majority of people in the US are paid every two weeks and we are close to the middle of the month so millions will be funding their pension accounts. That represents a flood of fresh capital into the markets over the next couple of days, which has the potential to tip the balance of sentiment from nervous to bullish so keep your eyes peeled.
All the best,
Eoin Treacy
Capital & Conflict
Category: Economics