FA Center: Wall Street always has a story to tell, and the best investors know to expect plot twists.

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Wall Street is a great storyteller, and the stock market’s record reads like a long collection of short stories. Investors need to identify not only what each story is about, but every aspect of the plot mechanics that makes it worth reading.

Investors also must consider both the horizontal and the vertical dimensions of the story. The horizontal aspect refers to the timeline of events, while the vertical one depicts the changing levels of investors’ tension over the course of the narrative. Wall Street is great at creating tension and sustaining it for months, sometimes years, all the while engaging and captivating investors who keep returning for the next instalments.

Every tale comes with a “clock” — an event that lets investors know when it will end, so that they can focus on the critical components of the plot and forecast how it will conclude. Often a key macroeconomic metric such as unemployment, inflation, or GDP growth is the clock. Sometimes a political or regulatory event, like a presidential election or a meeting of central bankers, is the clock. At other times, it’s a geopolitical event. Over the course of the story, tensions rise and fall. Finally, as the clock runs out, tensions peak before being resolved. 

Another element of a good story is what writers call a “gun” — an event that changes everything once it goes off. Wall Street is great at establishing the gun early in the story, then hiding it and bringing it back from time to time so that investors always know it’s there but are still surprised when it goes off. Once it does, tensions resolve and the story reveals its happy or tragic ending.

Lastly, what keeps investors engaged is a lack of dead space between stories. Wall Street never fully lets tensions in one story die before introducing what appears to be an even bigger threat for investors as the subject of the next story, like a trailer for the sequel shown at the end of a movie at the theatre. For example, late in 2022, the inflation crisis did not completely resolve before emerging concerns about the fate of the U.S. economy took over as the next chapter to be read in 2023.

In 2021, the episode was about the ineffectiveness of the Federal Reserve, namely whether it was falling too far behind the inflation curve. The clock was the timing of their admission that inflation was not as temporary as they had thought. And the gun was the FOMC minutes and speeches by Fed Chair Powell. Evasive and noncommittal language during those announcements early in 2021 momentarily raised tensions until finally, in November 2021, the gun went off, and the Fed admitted they were wrong about prices. However, tensions did not fully ease before the risk of hyperinflation — a bigger crisis — was introduced during January 2022 as the next story for investors to focus on. 

In 2022, hyperinflation became the story, and the clock was the timing of the final interest rate increase and recognition that the Fed had succeeded in bringing down inflation. The gun was the monthly inflation data, and it would only go off once inflation was back below the Fed’s target. Tensions were raised or lowered at each release as central bank watchers exploited the differences between the many definitions of inflation, and which one mattered most to the Fed.

After seven consecutive monthly declines in the headline inflation, the gun went off and the Fed finally moved to a smaller (25 basis-point) rate hike. The Fed announced that its fight against inflation, although not over, was heading towards resolution. At the same time, Wall Street introduced the topic of an economy that will suffer from a prolonged period of high interest rates, opening up the next story before tensions from the inflation one could be fully resolved.

The story so far

In 2023, the debate is about whether the U.S. economy is heading for a soft or a hard landing. The clock is the timing of the first rate cut (a.k.a., the pivot) when the Fed will switch from fighting inflation to preventing a recession. The gun is GDP growth data, and it will go off only on the second consecutive quarterly release of negative growth (a.k.a., the technical definition of a recession).

Tensions will be raised and lowered throughout the year by contrasting the resilience of the jobs market and consumer spending, with expectations that inflation has been defeated and the Fed would turn to supporting the economy and bringing the story to a resolution. Until then, the potential for a “no-landing” scenario is keeping investors guessing about each upcoming interest rate decision and raising the stakes at each FOMC meeting. 

Lower tension in the fourth-quarter of 2022 after several consecutive monthly deceleration in consumer prices encouraged impatient investors to skip ahead in the book, already anticipating a happy ending to the inflation story. After a cursory reading of the recession story of 2023, they concluded it would have a short clock and that the Fed, fresh from its victory against inflation, would quickly pivot to recession-prevention mode.

But in this twist-and-turn storyline, tensions rose again in February amid stronger-than expected employment and consumer spending data, followed by several speeches by Fed officials slamming the door shut on rate cuts this year. These events have reset the 2023 story’s clock to an early 2024 timing at the earliest. And to raise tensions early, some on Wall Street say the Fed, after a smaller rate hike of 25 basis points in January, may return to bigger rate hikes in coming months.

It’s too early in the 2023 storyline for Wall Street to give us the 2024 plot, but we can envisage two possible scripts as contenders for next year depending on how this year’s story ends.

If the current story has a happy ending, where the Fed achieves a soft landing, inflation continues to decline towards target levels, unemployment rises, and consumer spending declines, then 2024 could be a light tale about getting the economy to return to a growth path. In this scenario the clock will be based on reinflating the economy and achieving 4% GDP growth, and the gun will be Fed rate cuts, with tensions being raised of lowered via the quarterly earnings reports.

If inflation remains stubbornly high in 2023, forcing the Fed to keep raising interest rates and keeping them higher for longer — causing a hard landing of the economy — then 2024 could well be a tragedy about rising corporate defaults rates and a credit crisis. In this story, the clock would be set to end in a market crash, and the gun would be the fed funds rate decision, with a potential bailout of the economy as the gun going off. Additionally, next year being a presidential election year in the U.S. adds another level of tension as the political clock runs down to the November results.

Being an investor is like being a member of a book club where everyone is reading the same book and discussing the same chapter each week. Stick with the story, don’t fall behind or skip ahead, and keep in mind that Wall Street doesn’t write to be liked, it writes to be remembered. Whether this is a good or bad memory for your portfolio will depend on your skills at reading the market. 

Olivier d’Assier is head of applied research APAC at Qontigo, a Deutsche Boerse-owned financial analytics and index provider.

This article was originally published by Marketwatch.com. Read the original article here.

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