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The Winter of Our Discontent

It's going to get a lot colder before we're through

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On a clear day you can see forever

What are the markets trying to tell us about where we are in the economic cycle?

View from the Trenches

Yesterday was one of those days that we in the trade call "bananas". The market indices fell by over 5%, and then rose again to close higher than where they opened, an intraday swing of nearly 6%. Given the double-digit annual returns of the past three years, that seems like a relatively small amount. When viewed from the perspective of average historical return for US equities, it was about half a year's average annual return. That's a lot. It would be like going to the casino and staking half-a-year's salary on black.

Where do we go from here?

So, what does that tell us about the future trajectory of the American economy? Only that we can't say for sure, and that many market participants strongly disagree. The equity market tracks gross domestic product growth over time. Leading indicators of GDP have been mixed or flat recently, meaning that economic growth should be lower. We should therefore expect to see GDP growth trend lower, too. Higher inflation readings have convinced the Federal Reserve to curtail its asset purchase program, and the market now fully expects it to start raising benchmark interest rates in March of this year. Higher rates mean less capital sloshing around in the economy, as more investable dollars find their way into savings. Less liquidity means slower growth, and slower growth means lower equity market prices. Lower equity prices mean that we've likely seen the top of this market, and that equities should trade flat-to-down over the next few quarters until or unless economic conditions change.

What can we expect to see in the near term?

Market volatility is typically at its highest as consensus changes. We just witnessed an extraordinary amount of volatility. We should expect to see a change in consensus opinion of commensurate size. The end of an economic expansions is typically marked by equity price volatility.

We get our first read on quarterly GDP growth on January 27th, so the growth picture will come into sharper focus. Forecasts show continued economic expansion, ranging from 5.5% to 6%. This has already been priced into markets, but a substantially higher or lower number can lead to ructions in the market.

Additionally, yields should continue to hike higher as the Federal Reserve responds to high inflation readings. Its preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, gets released January 28th, so we will soon get to see what they see. Expect a higher reading, naturally, but it will be the rate of change that will matter most for forecasting inflation. Consensus is for a 5% increase, but a dramatic difference to the upside or downside will impact both Treasury yields and consequently growth stocks.

Otherwise, rafts of economic data are due out in the next two weeks, meaning that we will have a much better idea of where we are in the economic cycle before the fortnight is out. Given rough seas, it pays to batten down the hatches.

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