At any given time the market will be pulled up or down by positive and negative triggers. That’s why markets are volatile. When the positive triggers are dominant a bullish trend will be formed, and when the negative triggers weigh over positives, markets will turn structurally bearish. Even though long-term trends are established by GDP and earnings growth, in the short to medium-term, other factors like liquidity, interest rates, exchange rates and expectations around these macros can exert an undue influence on the market.
The important question now is: How are the markets likely to trend, going forward? Let’s get the economy-market construct in perspective. In 2020 the global economy slipped into one of the worst recessions in modern history, triggered by the unprecedented lockdowns all over the world. Panic reaction in markets in March 2020 led to one of the sharpest crashes in market history. But, starting April, markets started to climb up steadily aided by the unprecedented liquidity infusion by the leading central banks of the world, led by the Fed. Discovery of vaccines to contain the pandemic and Fed’s declared ultra-loose monetary stance to keep interest rates near zero through end 2023 gave fodder to the bulls which kept on charging. Globally markets scaled newer peaks. The economy-market disconnect was conspicuous; but the organised sector, which the market represents, started doing very well, justifying the bulls.
Humongous liquidity infusion by the leading central banks (above $ 10 trillion) should have created inflation. But inflation had ceased to be a monetary phenomenon in the developed world for more than a decade now. Instead of pushing up the prices of goods and services, liquidity pushed up prices of assets like stocks.
But low CPI inflation and high asset price inflation cannot sustain for long. Even though the Federal Reserve declared that it will keep rates unchanged till end 2023 and that it will tolerate higher inflation, the markets started fearing the return of inflation. The US 10-year bond yield, perhaps the most important macro indicator in the world which can move global financial markets, started rising leading to a mild sell-off in February 2021 and now on May 12.
Inflation data released in the US on Wednesday showed higher-than-expected numbers. YoY CPI inflation spiked to 4.2 percent, the highest since 2008. Core inflation climbed to 3 percent, the highest since 1996. Reacting to the worse-than-expected inflation numbers, US markets corrected sharply: The Dow, Nasdaq and S&P crashed by 2 percent, 2.1 percent and 2.67 percent, respectively. The US 10-year yield rose above 1.69 percent.
Inflation: Structural or transitory?
Economists and market experts are divided on the nature of this inflation. Some see it as transitory while others fear that it will become structural. The jury is still out on this. If inflation cools off in the coming months and the present growth momentum in the global economy continues, growth will trump inflation and the markets will bounce back. On the other hand, if inflation impulses get entrenched, the bond market will push up the yields, negatively impacting equity markets. This bond bears versus equity bulls fight has many more rounds to go.
Globally markets are highly correlated. So monitor the US inflation numbers, bond yields and market movements even while tracking the COVID data and macros back home.
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