1) The significant re-pricing of inflation expectations over the past month shows that the market has
been worrying more and more about an overheating of the economy. That is why rates have moved higher. And
these fears culminated on Friday with wage inflation hitting a post-crisis high. And it is the threat of
higher inflation and higher rates that is worrying the stock market because higher wages means lower
profit margins and higher inflation means faster rate hikes from the Fed as the FOMC tries to slow down
the economy and ultimately the revenue growth of S&P500 companies.
2) The market does not
expect the ongoing stock market correction will have any meaningful negative impact on the real economy;
if the market expected the correction to trigger a recession, then inflation expectations would also have
After a stellar 2017 and an even stronger January, risk assets have
undergone a sharp pullback in the last week. Initially triggered by higher rates as markets repriced
inflation expectations higher, the episode evolved into a technical spout of volatility exacerbated by
The pullback is healthy, after a highly unusual stretch of market
tranquility. For instance, the S&P 500 had not had a 3% pullback in over 300 trading days; market
positioning had become stretched. However, the moves now appear overdone. We are now well past the
typical 3-5% pullback, and the sell-off has gone beyond that during 2013’s Taper Tantrum which was
triggered by a much sharper rise in rates.
Fundamentals remain supportive of risk assets. The
robust, broad-based global expansion continues and inflation will at last accelerate in 2018. We expect
these trends to evolve steadily enough for central banks to tighten monetary policy gradually as planned.
Strong growth and rising but not high rates should continue to support corporate earnings and equity
valuations even as bond yields steadily rise.
Still, we expect market turbulence to return
this year. Pullbacks and volatility will become more common as investors adjust to rising interest rates
and capital is allocated out of risk assets and into higher-yielding fixed income. More volatility should
not derail the underlying economic expansion or fundamentally dent risk assets, but it will make markets
more bumpy and less predictable.
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