Economic expansions and bull markets in equities do not die of old age. They come to an end because a tightening of financial market liquidity ultimately curbs economic growth and causes a recession. Typically, it is the Federal Reserve that precipitates tighter liquidity conditions as it tries to tame excessive inflation. Recently, two well-known hedge fund managers have cautioned that the decade-long bull market will soon come to an end. One says he is drastically reducing his exposure to all financial assets; the other says he is selling stocks into further market strength. Their arguments, although hedged with respect to timing, are quite similar. Basically, both argue that stocks are fully priced and are dependent on a continuation of the “Goldilocks” scenario in which the recent trend of rising corporate profits, low inflation and plentiful financial system liquidity will continue beyond this year. They contend that inflation is picking up and that the Fed, which is already withdrawing liquidity as it gradually shrinks its balance sheet, will respond to higher inflation by turning even more hostile by 2019, reducing surplus liquidity, driving interest rates higher, and reducing the present value of a stream of future earnings. Ultimately, they expect the Treasury yield curve will invert due to Fed policy, and this has always triggered an economic recession with declining corporate profits and substantially lower stock prices.
Both may turn out to have been prescient, but we think a deeper dive into their arguments is warranted. What neither of these gentlemen mentions as a worry is the massive overhang of Emerging Market debt as well as US government, corporate and household debt. It might not take much of a rise in interest rates to cause a deflationary debt crisis. The confluence of shrinking the Fed's balance sheet, a higher Federal Funds rate, and the financing of a $2 trillion fiscal deficit in 2018-19 will significantly shrink the current pool of surplus liquidity. That’s OUR biggest concern.
Admittedly, there are several forces that could end the current expansion. Right now, the economy is growing at an accelerating pace. Second quarter GDP growth could well exceed 3.0%. There are widespread shortages of skilled labor, and recent data suggest that job openings are greater than the pool of unemployed workers. There is little doubt that if employment growth peaks, the impact would certainly crimp the economy. Also, as interest rates rise in the U.S., the Dollar will likely strengthen, which will impact our exports and the translation of foreign source earnings. Of course, the ham-fisted trade negotiations with Europe, China and NAFTA could devolve into trade war, with a seriously negative impact on growth and corporate profits.
But so far, the rise in inflation has been quite modest, as excess capacity, fierce competition, new technologies and globalization in an environment of only modest global growth are all keeping a lid on corporate pricing power. Moreover, wage growth is still running below 3% per annum, and certainly not contributing to “wage push” inflation, a concept to which we don’t subscribe anyway. A meaningful upturn in productivity would enable faster wage growth, and support increased personal consumption, thereby enabling faster overall growth and higher corporate profits. A pickup in Capex would likely boost productivity, but this has not yet occurred. However, given demographics in the developed world, the change in Fed policy already underway, and the intense price competition, the risk of runaway inflation (e.g., the 1970s) seems low.
Ergo, the simple fact is that currently nobody can have high conviction regarding the timing of a confluence of events (higher inflation, higher interest rates, tight monetary policy, declining corporate profits) that will trigger the end of the bull market and perhaps cause an economic downturn. All that investors can do is stay alert to some indicators that have proved reliable in the past. Because the stock market is far more volatile and much less liquid than in years past, investors will need to move quickly and decisively when the evidence begins to appear.
Market based indicators are of primary importance. The yields on 2-year and 10-year Treasury Notes are the most sensitive to (a) the growth rate of the economy and (b) the near-term intentions of the FOMC. So far, the 2-year note has reflected the gradual steps the Fed is taking to remove excess monetary stimulus. The rise in the 10-year yield has been modest, reflecting muted inflation. Although the spread has narrowed to less than 50 basis points currently, there is yet no sign of an inverted curve. Moreover, several Fed governors have expressed concern about the damage an inverted curve would do to the economy, and have cautioned that the FOMC must observe this indicator. Corporate bond spreads over Treasuries have not yet signaled stress in the capital markets. BBB yields at 4.5% are quite tight at about 1.5% above Treasuries, and High Yields are extremely tight at about 3.5% over the 7-year T-Note.
Another pair of indicators which bear watching are the relative growth rates of nominal GDP and M2. Currently, nominal GDP is running at close to a 5% annual rate, while M2 growth has slowed to only about a 3% pace. This suggests the beginning of a liquidity squeeze, but the lead time for it to impact the stock market can be quite variable. Because corporate cash holdings are extremely high, capital spending is growing only modestly and loan demand is tepid, the impact on the financial markets may yet be some ways off.
Commodity prices, including oil, are reliable indicators of economic strength/overheating. Both metals and agricultural commodities are generally firm in price but remain far below prior peaks. The same is true for oil. At this time none of these signal an overheating economy or rising inflation.
Stock market valuation by itself is rarely an indicator of an imminent correction, nor a full-fledged bear market. Stocks always fluctuate widely around the concept of fair value, which, of course, depends on both the level and trend of interest rates. A rise in rates in the absence of inflation is typically a sign of a robust economy. Up to now, that’s what we are witnessing. The current consensus forecast for S&P 500 earnings in the forward 12 months is about $160. At 2800, the Index would be valued at about 17 times this projection, equivalent to a 6% earnings yield, still well above BBB yields at 4.5%. If that spread closes, we would become concerned.
One thing in which we have high conviction is that the members of the FOMC do not want to precipitate a recession, in part because the risk of runaway inflation is remote and also because of the political risk of jeopardizing the Fed's independence. We also know that historically the FOMC follows interest rates. It does not lead them. If that practice holds, then it will be up to the “Vigilantes” of the bond market, who are the first to become alarmed by the imminent threat of excessive inflation. They will be the ones we believe who will signal the end of this bull market in equities.