The correction that began on January 30, and which may not yet be over, was triggered by several events. The fundamental events were first, the release of new data showing rising wages; and second, increasing acceleration in the rise of long-term interest rates. Obviously these are related. The sharp correction indicates that investors are at long last really settling into the realization that the strong economy and the Fed’s first steps to normalize monetary policy mean that inflation will appear, rates will rise, and the boost that years of ultra-low rates have given to stocks will dissipate.

The correction was made worse by difficulties and failures in a few technically flawed exchange-traded products that had allowed investors to place bets on volatility remaining low. The stunning spike in volatility caused huge losses in what had become a very crowded trade during the extended low-volatility period of the past year. There was certainly some forced liquidation of stocks as that trade went from obvious to catastrophic in the course of a single day.

Stepping back, and looking at all of this philosophically, there is little fundamental reason for concern in the medium term. The most probable outcome is that the Fed is at last handing off responsibility for growth to an economy that can handle it. Rising corporate profits will more than compensate for the withdrawal of stimulus. After a period of psychological adjustment, with investor enthusiasm renewed by the perception of good deals created by the correction, the market can resume its march.

Of course, that is the most probable scenario, and our job is to contemplate the risk of sub-optimal or very positive scenarios as well.

The most obvious “difficult” scenario is one where the current correction continues with choppy recoveries followed by new lows. We note that both the historical and the current fundamental backdrop usually lead to further market highs and periodic corrections as investor fear over rising interest rates flows through the market.

In our opinion 2018 will turn out to be a year characterized by volatility, but one that also eventually embraces new stock market highs. We believe that the best way to benefit from both the volatility and the rotation to new highs is to own stocks in the industries that most benefit from a rising interest-rate environment. These industries include banking; financial services; high-growth technology; industrial metals; industrial manufacturing; stock brokerages where the firms have superior internal bond and stock trading prowess; and companies in emerging markets which can grow as insurance and technology become more widely adopted — in fast-growing countries such as China, India, Korea, Taiwan, and Chile.

The graph below shows a few similar recent equity market corrections… and illustrates how the “sorting out” phase of choppy volatility can be short and sharp, or uncomfortably long.


Source: Canaccord Genuity

Navigating 2018 effectively, then, will mean close attention to the variables that could cause further volatility. That will include Fed communications and behavior — with the current regime change at the Fed signaling a transfer from an academic orientation at the top to one that is more pragmatic under Jerome Powell. It will also include monitoring interest rates, as well at the economic forces that shape the interest rate environment.

Foremost among these is inflation.

The Inflation Landscape in 2018

Market participants are now in a state of high anxiety, watching inflation. And indeed, even before this state of high anxiety was sparked by the selloff, inflation was getting attention from the people who notice it first — companies with significant wage and raw material expenses.

Foremost among these are U.S. manufacturers, construction companies, and food companies, which are already commenting on rising labor costs and rising material costs, particularly materials such as steel, aluminum and copper, as well as other industrial inputs. Packaging and transport costs are rising. Food costs are rising, and many restaurants will raise prices to protect their margins (and those who can will accelerate the adoption of automated kiosks to reduce labor costs).

These costs rose in 2017 as the global economy accelerated, and that rise is continuing — although at a reduced pace in many cases (aluminum prices were up 30% last year). Now, however, the market is paying more attention.

Inflation data arrived on Wednesday morning, coming in above expectations — core CPI, excluding volatile food and energy, rose 0.3% in January. On a positive note, over the last 12 months, the CPI has only risen by 1.7%. After some early morning jitters the market accepted this news and rose vigorously on the day. This behavior bodes well for the rebound from the recent correction.

Investment implications: The economic expansion is in its late stage, a period during which cyclical stocks typically outperform growth stocks. Many cyclical stocks, while buoyed by the robustness of the last leg of the global economic expansion, will face higher input costs as demand rises for labor and raw materials. We are bullish on many industrial manufacturers — two examples are Caterpillar [NYSE: CAT] and Boeing [NYSE: BA]. We are also becoming bullish on copper, particularly as China and India expand the use of climate control in areas that heat currently makes inhospitable for highly productive workers — copper will be needed to upgrade vast swathes of electrical infrastructure. We remain bullish on major growth tech companies, banks, financial service companies, and gold mining companies. We are cautious on some industries that could otherwise be benefitted by rising disposable income among American workers — for example, restaurants, which may see their profits crimped by rising labor costs.

Please note that principals of Guild Investment Management, Inc. (“Guild”) and/or Guild’s clients may at any time own any of the stocks mentioned in this article, and may sell them at any time. Currently, Guild’s principals and clients own BA. In addition, for investment advisory clients of Guild, please check with Guild prior to taking positions in any of the companies mentioned in this article, since Guild may not believe that particular stock is right for the client, either because Guild has already taken a position in that stock for the client or for other reasons.