2-3-18 10:10 AM EST | Email Article

By William Watts, MarketWatch

The stock market took a little of the "up" out of "melt-up."

The specter of inflation derailed an accelerating rally, ensuring that rising Treasury yields will remain the focus of stock-market investors in the week ahead.

Stocks tumbled sharply on Friday, with the Dow skidding more than 600 points. The S&P 500 and the Dow both posted their biggest weekly declines in more than two years. While Treasury yields have been creeping higher since last fall, the 10-year note's push to a four-year high above 2.83% on Friday appeared to trip alarms.

And it's not just a U.S. phenomenon:


The push higher on Friday came after the January jobs report (http://www.marketwatch.com/story/us-adds-200000-jobs-worker-pay-rises-at-fastest-pace-since-2009-2018-02-02) showed a pickup in wage growth. It underlined expectations that a tightening labor market will eventually work to push inflation toward the Federal Reserve's target of 2% and, possibly, scare policy makers into hiking rates at a faster pace than previously expected.

Still, the drop, coming after a "parabolic" acceleration (http://www.marketwatch.com/story/this-parabolic-move-for-stocks-has-some-investors-nervous-but-should-it-2018-01-29) of a stock market rally that saw major indexes set another series of records with nary a pullback in January, was widely viewed as overdue and perhaps even welcome by market bulls.

"The equity markets have been setting numerous records, relative to both price gains and the absence of volatility ...Though it's never fun, LPL Research believes stocks needed to pull back from their record march," said John Lynch, chief investment strategist for LPL Financial, in emailed comments.

Check out:The Dow's tumultuous history, in one chart (http://www.marketwatch.com/story/the-dows-tumultuous-120-year-history-in-one-chart-2017-03-23)

The center of attention Friday was the January jobs report, particularly a 0.3% monthly rise in average hourly earnings, which pushed the yearly increase to 2.9% -- the strongest since the end of the 2007-2009 recession (http://www.marketwatch.com/story/big-pay-gains-in-january-favor-high-income-workers-over-minimum-wage-workers-2018-02-02).

But the real concern might be productivity data (http://www.marketwatch.com/story/us-productivity-dips-01-in-fourth-quarter-ends-2017-on-sour-note-2018-02-01) that was released earlier in the week, said Ed Keon, managing director and portfolio manager of QMA, the quantitative equity and dynamic asset allocation business of PGIM, with around $133 billion in assets under management. That report showed that U.S. productivity declined 0.1% in the fourth quarter, versus expectations for a 0.2% rise.

A combination of sluggish productivity growth, weak labor force expansion and rising wages are a recipe for a pickup in inflation, Keon said. In addition, the potential economic growth rate of the economy, given weak productivity gains and a tepid expansion of the labor force, is probably a little less than 2%, he said. Matched up with an economic growth target of around 3%, that means the economy would be pulling growth in from future years.

"From the stock market's perspective, if you then price the growth that's been pulled forward as if it's going to continue indefinitely, you're going to end up overpricing assets," he said. The nearest example of that phenomenon was seen in the late 1990s when worries over the "Y2K bug" saw companies accelerate purchases of software and hardware.

Keon said QMA remains bullish and is still overweight equities, but did raise some cash over the past week as both equities and bonds sold off.

The market jitters come as Jerome Powell prepares to formally take over as chairman of the Federal Reserve on Monday, replacing Janet Yellen (http://www.marketwatch.com/story/yellen-to-join-bernanke-at-washington-think-tank-2018-02-02). While the Fed didn't make many waves at its February policy meeting, the changeover adds to the uncertainty that surrounds a changing macroeconomic backdrop.

Booming U.S. growth at full employment alongside a global expansion and rising commodity markets means real, or inflation-adjusted, short-term U.S. rates are set to turn positive in 2018 for the first time since 2008, said Lena Komileva, chief economist at G+ Economics, in a note. That means higher rates and a steeper yield curve than the market now expects.

"How Jay Powell's Fed reacts to a more volatile market environment and how markets react to a more hawkish Fed path ahead will be the making of market momentum and composite asset returns in 2018," she said.

Read:What investors need to know about Fed decision days in 2018 (http://www.marketwatch.com/story/heres-how-the-stock-market-and-other-assets-perform-on-fed-decision-days-2018-01-31)

The economic data calendar is relatively light for the week ahead, highlighted by the ISM services gauge for January on Monday and the December trade deficit on Tuesday.

Earnings season continues, with highlights including Walt Disney Co. (DIS) , General Motors Co. (GM) , Tesla Inc. (TSLA) and Twitter Inc. (TWTR) . See the previews: Disney (http://www.marketwatch.com/story/disney-earnings-is-disney-positioning-itself-for-the-future-or-clinging-to-the-past-2018-02-01), Tesla (http://www.marketwatch.com/story/tesla-earnings-model-3-is-still-the-issue-investors-care-most-about-2018-01-31) and GM (http://www.marketwatch.com/story/gm-earnings-will-the-good-times-keep-on-rolling-2018-01-29).


(END) Dow Jones Newswires

February 03, 2018 10:10 ET (15:10 GMT)

Copyright (c) 2018 Dow Jones & Company, Inc.
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