Bull Markets, Shifting Catalysts and Evolving Narratives

Stocks in the US are back in bull market territory this month but don’t tell that to the market bears.

That’s because it seems like just around every corner, there seems to be a risk that could take the steam out of the current rally and send risk assets into a sharp drawdown only matched by those related to recent economic, political, or security dysfunction.

Make no mistake, this year’s risk asset rally is likely to be one of the most hated bull markets in history. That’s because some major indices continue to charge higher even as various indicators point to hazards ahead for the US and global economy and hence, corporate earnings that underpin corporate asset valuations.

And you see, this is a particular problem for some investors because the thinking goes that it’s foolhardy to be fully invested at a time of rising interest rates, slowing economic activity, and looming geopolitical risks because these events have the potential to topple risk asset prices that already appear to be overvalued compared to many historical measures.

Even so, some market bulls are taking even greater risks as they look past events that are likely already priced into the market and shift their focus to up-and-coming developments that could supercharge economic growth over the next decade.

So, who’s got it right?

Is the current rally nothing more than a bull trap, that could lead to a renewed bear market and set the stage for one of the sharpest downturns in quite some time, as rising interest rates trigger the next bank panic and economic recession?

Or does this bull market have legs, and will it continue to charge higher into the second half of the year?

Now, while it’s still unclear whether bulls or bears are making the right call, which way the market goes in the months and year ahead will likely depend on the dominant market narratives currently underpinning investor sentiment.

How Narratives Influence Market Behavior

And, so what do we mean when we talk about market narratives?

Well, a market narrative is a story that market participants tell themselves to rationalize a near-term or long-term investment decision. To be sure, all you need to do is turn on financial news channels or scroll through social media to get a sense of the story that some market participants are telling themselves and others as they defend their investment views.

And while these views can range from a call on a particular stock, sector, or asset class within the markets, what often drives the broader direction, and hence general investor sentiment, is the macroeconomic narrative.

And what do we mean here?

Well, let’s use a hypothetical example to illustrate this point. Imagine we’re back in a period of prolonged economic stability, like between 2014-2019. During this time, GDP had been rising steadily, unemployment was at historic lows, and inflation was largely under control.

Generally speaking, in a stable period like this, it created a prevailing narrative of continual, albeit moderate, growth in US corporate earnings.

As a result, risk assets went on a bullish run, with many indices hitting all-time highs. In fact, from the start of 2014 to the end of 2019, the S&P 500 index nearly doubled in value. That’s because investors got used to this steady-state, predictable, low-volatility market environment and just kept buying, driving prices ever higher.

Now, you’ll likely recall that the narrative at the time was that while the Fed would have to raise interest rates to curb potential economic and market asset bubbles, but it was constrained by the economy’s addiction to near-zero interest rates and stubbornly lower inflation that wouldn’t move no matter what policymakers threw at it. Therefore, low-interest rates and easy money policies would allow stocks to rise for an extended period of time.

So then, when we think of market narratives from this perspective, it’s this sort of thinking that shapes investor behavior, making them more risk-tolerant as they come to expect that the good times will continue. This outlook led to increased investments in equity markets, higher asset prices, and arguably the formation of asset bubbles.

At the same time, economic participants, namely households and businesses, had also become influenced by the narrative as well. Given positive investor sentiment, firms had been more willing to issue new stock or debt offerings, and many investors readily stepped in to buy them up.

What’s more, financial institutions continued to openly lend at low-interest rates, fueling economic activity even more, and households gladly opened their wallets to spend.

Now, let’s say new information emerges that challenges this narrative. And what could this be?

Well, this catalyst, or new information, could come from reports of potentially disruptive geopolitical tensions, or signs of an economic slowdown in the US or some major economy abroad. And why are such developments relevant when everything else seems to be going ok? 

Well, this new narrative of impending uncertainty has the potential to shift investor sentiment quickly. And when an unfavorable catalyst crops up, the risk-averse investors might start pulling out their investments, leading to a selloff in the markets, increased volatility, lower asset prices, and a decline in economic activity.

At the same time, this narrative shift could affect corporate and financial institution behavior as well. That’s because firms might hold off on issuing new securities given the uncertain environment, and banks might tighten their lending standards.

How New Catalysts Lead to Narrative Shifts

Alright, now it’s critical to note that these narratives don’t operate in isolation. That’s because they’re constantly interacting with catalysts like changing economic data, government policies, and geopolitical tensions that can influence investor psychology. To be sure, when new catalysts present themselves that challenge the current market narrative, it can become a self-fulfilling prophecy, where the belief in a narrative can cause actions that make the narrative come true.

For example, if investors believe there will be a market downturn, their selling activity can actually cause the downturn. Indeed, if we extend our earlier narrative example beyond the end of 2019, you’ll likely recall that an unexpected catalyst in March 2020 led to a dramatic shift in the market narrative.

And do you recall what that catalyst was?

That’s right, it was the US government announcing a national emergency in response to the COVID outbreak, which paved the way to an unprecedented economic shutdown and trillions of dollars of stimulus to support the economy and markets. Initially, the national emergency announcements led to a sharp market selloff due to the negative catalyst that was the pandemic, but later supported by a positive catalyst that included supportive actions by policymakers that paved the way for an extended market rally only weeks later.

This process underscores the importance of monitoring and understanding the prevailing market narrative and potential catalysts, as they can greatly influence investor behavior, market activity, and, ultimately the economy at large.

Narratives and Catalysts in the Current Environment

Now, considering where we are today, it would seem that there is still some uncertainty about the dominant market narrative. To be sure, the debate between bulls and bears is what leads to price discovery and makes for a more-or-less healthy functioning market. And more often than not, those debates and how they play out in the market through price action are not just about the dominant narrative but also about how various catalysts could potentially influence the direction of the prevailing market story.

So, what are the catalysts that are currently under consideration by market participants?

Well, the dominant catalysts likely up for debate affecting the broader narrative center on 1) inflation, 2) central bank policy, 3) financial instability, and 4) the potential for an economic downturn.

Inflation and Interest Rates Normalizing

Now, as it relates to the first two points on inflation and central bank policy, you’ll likely recall that uncertainty surrounding where inflation was headed coupled with the fact that policymakers seemed asleep at the wheel, were the catalysts that led to last year’s bear market selloff.

Indeed, inflation that was supposedly transitory due to supply chain constraints transformed into stickier, widespread price hikes from across most economic sectors, leading to declining purchasing power and dented household wallets and confidence.

Now, it’s essential to note that central bank policymakers usually aim for a low and steady inflation rate as their target because price stability allows for better financial planning and fosters overall economic well-being among households. That’s because when prices are stable, households can more accurately predict their expenses, which makes it easier to budget and plan for the future.

And, so, without price stability, it’s difficult to know how much money you’ll need to spend on essential goods and services. And when this happens, it can lead to uncertainty and possibly financial hardship. And it was this catalyst that many market watchers had been calling out for quite some time. And, when Fed policymakers finally reversed their stance on “transitory” inflation and began rapidly raising interest rates 18 months ago, the dominant market narrative shifted.

But now, with headline inflation having fallen to just over 4% in May for its lowest reading since April 2021, and producer price inflation falling for 11-straight months, it appears that the two catalysts that had threatened economic stability, that is, high inflation and high-interest rates are likely to come back to normal soon.

And for many of the bulls out there, it’s arguably this outlook that has renewed investor demand for risk assets, and underpinned the current market rally as many market participants are looking past the risk of high inflation, and now pricing in central bank rate cuts by the start of next year as price stability returns to the US economy.

Financial Instability and Economic Recession

And so, if inflation seems to be stabilizing and bringing policymakers to the point of normalizing interest rates, you might be asking yourself, “Well, what about the lingering financial instability issues and the looming economic recession on the horizon? Don’t these catalysts have the potential to derail the current bull market rally?”

Well, the short answer is: it depends. On the one hand, a spreading bank contagion could bring into question the health of the US and global financial system and spark a greater crisis of confidence in US and global financial markets. To be sure, this risk, while less noticeable than it was a few months ago, remains a salient threat. That’s because, even as headlines surrounding the failures of small regional US banks have eased, data according to the Federal Reserve show that banks are three times more reliant now on emergency borrowing from the central bank than during the height of the pandemic.

What’s more, the latest Senior Loan Officer Survey shows that both large and small US banks are tightening lending standards and reducing overall lending to businesses and households. Indeed, in recent months, many financial institutions have announced planned exits from various auto lending and mortgage markets. And with central bank policy rates poised to rise to their highest levels in two decades, market bears could argue that it’s all but certain that an economic downturn is just around the corner.

So, with all that said, it’s possible that these two catalysts may have less bite than their bark. Make no mistake, many financial institutions are facing significant risks. Yet, it could be argued that the current plight of banks adjusting to higher interest rates likely has more to do with balance sheet management practices, than general systemic concerns related to the quality of assets held by these banks.

Indeed, this is a topic we wrote about several weeks ago and pointed out this distinction. Even so, the banks’ precarious position is likely to make them less willing to lend, especially at a time when collateral backing many of the loans, like real estate and autos, are falling in value along with the decline in overall inflation.

And what about this recession that we’ve been waiting for the past year? Well, it’s true that higher interest rates have historically led to lower hiring activity and so the potential for layoffs, and subsequent weaker household spending remains an elevated risk.

Even so, this labor market has been one of the most stubbornly strong markets we’ve seen in decades. To be sure, compared to historical recessionary periods, labor market data this time around has been more resilient, suggesting that, while economic growth likely will slow into the end of the year as many economists predict, a rise in unemployment likely could be less severe than we’ve seen in cycles past.

Bull Markets, Evolving Narratives and Shifting Catalysts

So then, assuming that inflation and interest rates come down to more normal levels, regional banks find their footing, and the economy experiences a soft landing in the second half of the year, then, there is a case to be made that this bull market has legs.

Again, you might ask yourself, “But aren’t valuations already stretched?” and “Isn’t the current risk asset rally being led higher by a handful of the largest companies?”

Certainly, from this perspective, some assets appear overpriced. These assets are largely tech related that have rallied in line with expectations that artificial intelligence will lead to future economic efficiencies. With that said, however, many assets remain attractively valued given the market selloff we’ve seen over the past twelve months.

Now, add to this the fact that there is a historic $1.3 trillion parked in retail money market mutual funds and a case could be made that we might see a reallocation in the bull market currently supported by a handful of expensive names to one supported by a broader base of cheaper or fairly valued names as cash moves back into the markets once retail investors are convinced that negative market catalysts are likely to have less of an impact on the overall market narrative.

So then, from this perspective, is now the time to dive into risk assets? Well, if you’ve been trying to time your way into the markets this year, then you likely missed out on a number of opportunities. Indeed, if you’ve been following along with us this year, we’ve made a strong case for remaining fully invested in the markets despite perceived headwinds.

So, who’s got it right?

Is the current rally nothing more than a bull trap, that could lead to a renewed bear market and set the stage for one of the sharpest downturns in quite some time, as rising interest rates trigger the next bank panic and economic recession?

Or does this bull market have legs, and will it continue to charge higher into the second half of the year?

While the sustainability of the current bull market rally is questionable, we remain cautiously optimistic on the outlook for the US economy and financial markets alike. Here again, we believe that investors should remain fully invested in the markets and not try to time their way in and out in anticipation of changing market narratives. Rather, you’re likely best served by remaining committed to your disciplined long-term investment strategy.