Conventional wisdom holds that an expanding economy, with attendant gains in corporate profits, will support a continuing bull market in equities. The evidence of market history suggests this is not always quite so simple. The strongest gains in every new bull market occur even as the economy is still contracting, or at least nearing the end of the contraction phase, but before a recovery gets underway. It is during this period, which occurs long after stocks have discounted the recession and the accompanying decline in profits, that surplus liquidity in the financial system is at its greatest. Because households and businesses are still struggling to reduce their indebtedness, while at the same time monetary policy is flooding the economy with liquidity, the money has no place to go but into financial assets, both bonds and equities.
The U.S. equity market peaked in October 2007, shortly before the recession began, and the final stage of the bear market occurred between September 2008 and March 2009, first reflecting forced liquidation by leveraged investors and finally the capitulation on the part of individuals. Paradoxically, this final sell-off, always the steepest, occurred after the Federal Reserve had begun flooding the system with liquidity, but the fear factor resulting from the credit market freeze, post the Lehman bankruptcy, prevented most investors from taking advantage of bargain basement equity values. Since early March, however, the first stage of a new bull market has carried the Standard & Poors 500 Stock Index up more than 65%, supported by better than expected corporate profit results, reflecting enormous productivity gains, as well as a mountain of uninvested cash, in both the U.S. and abroad, seeking better returns than those offered by short term Treasuries and money market instruments.
There are now two prevailing schools of thought regarding the economic and stock market outlooks going forward. The first expects a long period of below potential economic growth, with Federal Reserve monetary accommodation continuing in place, as unemployment remains high and inflationary pressures subdued. Under this scenario corporate profit growth will be sustained by rapidly growing foreign source revenues, continuing productivity gains, and a weak U.S. dollar. Under this scenario interest rates would remain low and financial market liquidity ample, and stocks should continue to mirror individual company profit gains. A second school of thought expects the economy to give way to a double dip recession sometime next year as fiscal stimulus peaks out and a weak labor market curbs personal income and consumption gains, cutting short any inventory rebuilding and precluding a capital investment cycle. The continuing headwinds from a rising savings rate, tight bank credit, continuing home mortgage foreclosures and commercial real estate refinancing problems prevent a self sustaining recovery from taking hold. If this occurs, equities are likely to sell off for a time and then be range bound, at best.
In my judgment, however, there are two other possible outcomes, neither of which at this point is receiving much attention, but if either occurs, the first impact will be to prompt a significant correction in both the equity and fixed income markets. Both of these revolve around the exchange value of the U.S. dollar.
In the very near term there is the risk that the Dollar, which has just broken long term support, goes into a free fall against the Euro and Yen. The incredibly naïve statement from the Fed in the Minutes of its last meeting, to the effect that the Dollar’s decline has been orderly, could well be the trigger for a much sharper decline. Benign neglect is best left unspoken. What has up to now been viewed as a plus for U.S. exports and a stimulus to an economy in which personal consumption is struggling, would then become a source of considerable fear and uncertainty. The Fed would be reluctant to raise rates at this point in order to stem the decline in view of the nascent, slow recovery. Besides, higher rates rarely support a currency for long. Strong currencies derive from strong economies, not from interest rate differentials. The Fed might intervene in the currency markets, perhaps in concert with other central banks, but history shows that intervention rarely works unless the move is supported by economic fundamentals. A collapse of the Dollar would lead to sharply higher prices for the entire range of precious and industrial metals, energy and agricultural products. The resulting inflation fears would cause longer term interest rates to spike, which would do serious damage to all sectors of the residential and commercial mortgage markets. Finally, it would hasten the diversification by our trade partners into alternative stores of value for their currency reserves. The impact of all this on stocks, bonds and the economy at large would not be pretty.
On the other hand, if the macroeconomic data begin to surprise investors on the upside, the first impact will be to strengthen the U.S. dollar, which by itself will cause liquidation of the highly popular carry trade, resulting in a sharp sell-off in both equities and commodities. If the better data are also accompanied by an upturn in bank lending, then by definition some of the surplus liquidity in the financial system will be diverted back to the real economy, in all likelihood at higher short term interest rates, leaving less available to support financial asset prices.If, for example, the yield on the 2-Year Treasury Note, currently at about 0.73% were to move above 1.25%, together with a stronger dollar and increased private sector borrowing, the FOMC might well conclude that a self sustaining recovery was underway, even before the unemployment rate peaks out. The Fed has almost always followed interest rates rather than leading them, and under these circumstances a change to a less accommodative monetary policy would be inevitable, particularly given the recent huge expansion of the Fed’s balance sheet. All of this would contribute to the first major correction in the equity market since March. This need not foretell the end of the bull market, however. Once equities stabilize and begin to recover, the market’s leadership will in all probability rotate away from energy, materials, industrials and transports, all of which are major cyclical beneficiaries, in favor of a broader variety of growth stocks including consumer and technology issues.
No one can have high conviction in any of these outcomes at this time. The important thing for investment managers is to be prepared to respond quickly, whichever direction the economy dictates.
