Economic Commentary: Indicators Investors Should Monitor To Understand Market Direction

Written by CUNA Mutual Group Annuities

World financial markets are at an important inflection point. The extended period of market calm, complacency and record-low volatility has ended for the current investment cycle. The risk to both equity and bond markets is that economic data are too strong rather than too weak, creating a negative environment for inflation, monetary policy and interest rates.

In this month’s Economic Commentary, Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., shares his perspectives on key indicators investors should closely monitor to best interpret the important signals of the future direction of the fixed-income and equity markets.

Q&A With Robert DeLucia

How will consumer inflation be impacted by the end of the cyclical bear market?

The end to the cyclical bear market will likely be triggered by a significant rise in the inflation rate, compelling the Federal Reserve to adopt a more aggressive pace of monetary tightening. In fact, the Federal Reserve has been guiding markets to expect three rate hikes in 2018. A more aggressive rate-tightening cycle — with four or more rate increases — would be a negative for both bond and stock markets. Further dollar weakness would also be a negative for the U.S. and world economies because of its inflationary implications. Market expectations regarding future inflation can be tracked on a daily basis through the Treasury Inflation-Protected Securities (TIPS) market.

Could trade protectionism initiatives cast doubt on the market’s future?

Official moves in the direction of trade protectionism by the U.S. and/or other countries could be a serious negative in the outlook. The recent White House imposition of tariffs on steel imports is alarming, threatening retaliation by China and other steel exporting countries.

Should continued job creation and wage growth concern investors?

Continued net job creation equal to the recent monthly average of 180,000 would result in a further tightening in the labor market, greater shortages of skilled workers and more intense upward pressure on wages. It seems virtually assured that wage growth will trend higher in the coming months, but it is the pace and breadth of increases that will dictate the future thrust of monetary policy, and therefore, bond and equity market trends.

Can investor asset allocation and general sentiment toward investing influence the future direction of the fixed-income and equity markets?

Inflows into equity mutual funds and exchange-traded funds (ETFs) in January were the strongest on record; continued inflows would be bearish for the equity market. The equity market will remain at risk until there is evidence of less exuberance and more fear and risk aversion among stock investors.

What should investors look for in terms of peak equity market indicators?

Historically, credit spreads have been a reliable indicator of a peak in the equity market, with a lead time of approximately three to six months. Investors should also monitor equity market valuations. Currently at 18.5 and down from a peak of 19.2, a further decline in equity P/E ratios to below 17 would be supportive of a rising equity market. A continued increase to 20 or more would be a headwind for future price appreciation.

Are there any immediate red flags investors need to be aware of that signal significant negative shifts in the economy?

A major red flag for equity investors would be evidence of less bullishness on the part of corporate CEOs regarding future sales and earnings. Also, a sustained flattening in the Treasury yield curve would be a negative signal with respect to the economy and financial markets — indicating that the pace of monetary tightening has become sufficiently restrictive to trigger a sharp slowdown in economic growth.

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