How To Get Ahead Of The Next Major Market Narrative

How To Get Ahead Of The Next Major Market Narrative
Stéphane Renevier, CFA

almost 2 years ago5 mins

  • Narratives don’t just influence markets in a big way: they follow a typical cycle.

  • Right now, it seems that the reflationary narrative is starting to be replaced by a more challenging stagflationary or even recessionary one.

  • So pay close attention to which narrative is likely to take over, and position your portfolio accordingly to benefit from the shift.

Narratives don’t just influence markets in a big way: they follow a typical cycle.

Right now, it seems that the reflationary narrative is starting to be replaced by a more challenging stagflationary or even recessionary one.

So pay close attention to which narrative is likely to take over, and position your portfolio accordingly to benefit from the shift.

Mentioned in story

Let’s face it, investors are constantly trying to explain why markets are moving the way they are. And they do that in part by telling themselves new stories every few months: market narratives that allow them to rationalize every shift and make decisions accordingly. So if you’re able to tell when the narrative is about to shift, you could put yourself in a position to profit before it does. Here’s how you can do just that.

What is the main market narrative right now?

There are often multiple different narratives at any one time, some of which compete with each other. But there’s always one that’s dominant. That much becomes clear when you look at the narratives investors have been following since the start of 2020.

Level of interest about different macro themes based on Google searches. Source: Finimize.
Level of interest about different macro themes based on Google searches. Source: Finimize.

The market initially focused on the heightened recession risks caused by the pandemic, but it pretty quickly turned its attention to the economic recovery. That goes hand in hand with the strong V-shape recovery in stock prices we saw at the time. Then, as risky assets and commodities recovered, the environment known as “reflation” (high growth and high inflation) became the trendiest topic. That’s where we are right now – if potentially not for much longer.

Why might it not be for much longer?

As professional trader Brent Donnelly explains in his book “Alpha Trader”, most narratives tend to follow a seven-stage life cycle.

A new narrative starts to form: A few investors talk about a particular theme, but markets aren’t pricing it in yet.

Momentum starts to build: More and more investors take notice of the narrative, and they start to adjust their portfolios to reflect it. That “confirms” the narrative and fuels it even more.

It becomes the main market narrative: The media is now talking about this narrative, and the majority of investors have now adjusted their portfolios accordingly. This is when the price trend tends to be the strongest.

The first cracks start to appear: Certain data and events run counter to this narrative, and alternative market narratives emerge. At this point, price action tends to be choppier and investors who came to the theme early might exit.

There’s a “final hype wave”: Cracks or no cracks, the overall market is committed by this point. There are jumpy price moves and a general sense of euphoria among investors.

The narrative starts to turn: The peak of the narrative momentum has passed, but prices reach new highs. It’s at this point that investors anticipating a turn in the narrative make big trades to reflect that.

The narrative dies down: The market finds a new narrative to start the whole process all over again.

A stylized view of the typical narrative cycle. Source: Alpha Trader, by Brent Donnelly
A stylized view of the typical narrative cycle. Source: Alpha Trader, by Brent Donnelly

So what stage are we in now?

There are a couple of ways you can tell where we are in any given cycle.

Firstly, pay attention to how prices react to news around the main narrative, and to what extent alternative narratives get covered in the press. If no one’s taking a contrarian position, you’re more likely to be somewhere in the middle of the cycle. You might also want to look at the direction of changes in what investors are expecting. Ask yourself, for example, if they’re becoming more or less positive about the outlook for companies’ profit margins.

But ultimately, this is more of an art than a science. It’s always going to be subjective, and your best bet is to look at what’s going on in the markets and make an assessment based on what you see with your own eyes. In my personal opinion, the current reflation narrative is on stage six.

Here’s why. Firstly, prices are resuming their uptrend, suggesting they haven’t peaked yet. Investors are telling themselves that the stock market can handle interest rate hikes and heightened geopolitical risk, which is why stocks have risen over the past few days. This, despite rates and inflation pressures continuing to rise to worrying levels. And while bond markets are experiencing a slightly darker version of this narrative, the stock market is still quite positive about the future. It’s even back to where it was before the Russian invasion.

But since we’re in stage six, we’re also seeing cracks under the surface. And while this week’s market rebound seems to indicate that the outlook has improved, trouble is brewing. For one thing, some key leading indicators are pointing to a deterioration in growth conditions over the next month. The Federal Reserve’s aggressive plan for rate hikes has also led to record losses for bonds, while rates markets are expecting such a slowdown in growth that the Fed will have no choice but to reverse course and cut rates by 2023. What’s more, an increasing number of investment banks, asset managers, and more are turning more cautious about the macro outlook – even the traditionally bullish ones.

And in keeping with stage six, we’re starting to see some new alternative narratives making their voices heard…

So which narrative is next?

If we go back to our trend chart, you’ll notice that “stagflation” – the mix of high inflation and low growth – seems to be the main competing narrative right now. I believe this narrative will continue to dominate over the next few weeks, and that some investors may be preparing accordingly.

But if I had to bet which narrative will be trending in the next few months, I’d put my money on “recession”. You can see on the chart that this narrative is starting to pick up steam. I expect the slowdown in growth caused by higher inflation and interest rates to eventually lead to lower inflation. That just leaves us with a slowdown or reversal in economic growth to deal with.

Again, that’s just my take, and you might disagree. If you think one of the other alternative narratives out there – like stagflation, or a “Goldilocks” environment of lower inflation and robust growth – is more likely, you should follow your instincts and adjust your portfolio accordingly. My best advice is to take a close look at the geopolitical developments or key economic data that could impact that narrative, and work from there.

But if you do share my view, there are a few tweaks you could make to your portfolio allocation to prepare yourself for recession: defensive sectors like health care and consumer staples should do better than the overall market, while gold and even treasuries bonds – which aren’t priced for a change in narrative – could do well in this scenario. Keeping some dry powder in cash might also be a good idea.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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