What will kill this bull market?
The bull market has just entered its tenth year – one of the longest since WWII, but far from the strongest. Does that mean it still has legs or is the end of the economic cycle nigh? Portfolio Manager Mark Leach shares his thoughts.
The traditional adage amongst investment professionals is that bull markets very seldom die of old age but are rather killed off by the Federal Reserve. Since 2009 financial markets have been in a steady bull market as global economies recovered from a deep recession.
This period of expansion, while more prolonged than previous economic cycles, appears to be exhibiting similar characteristics.
Sustained growth and inflation have been for the most part limited since the recovery began but over the last two years major economies around the world have seen a synchronisation of growth and in the world’s most important economy, the United States, unemployment has now fallen from a peak of 10% to 4%. As with historic cycles the expectation today is that the US is reaching a point where higher wages and higher consumer confidence will drive higher inflation.
In response, central banks, tasked with controlling inflation, look set to raise interest rates, which in time can shift the economy from what was once a self-fulfilling spiral of positivity – falling unemployment, rising wages and increased confidence – to a negative spiral of falling confidence, reduced investment, rising unemployment and eventually a recession. The conundrum for central bankers remains – how to allow the economy to expand without letting it overheat.
Will Central Banks go too far?
The question that now preoccupies investors is how fast and how far interest rates will rise? To make these predictions more complicated, the data has been muddied by the fiscal measures undertaken by the Trump administration and the advent of a new Chair at the head of the Federal Reserve, Jerome Powell. Lower taxes have led to one-off employee bonuses, which in turn will likely lead to a spike in demand for goods and services. Powell’s task will be to unpick the temporary data points from the longer term underlying trends.
Markets have been protected to some degree in recent years by the concept of ‘the Fed put’ – the theory that the Fed is determined to prevent significant market decline by appeasing investors with more dovish (lower interest rate) policies. The interesting paradigm to emerge post Jerome Powell’s inaugural address was that expectations of the Fed funds rate have continued to rise while markets have weakened, suggesting the potential for a significant regime change.
Another concern relates to recent announcements of tariffs on steel and aluminium imports by the Trump administration. These have increased the threat of protectionism and raise the spectre of a trade war. This is a development we will have to watch carefully as any escalation could negatively disrupt global growth, impacting confidence and markets. In the previous two trade wars of the last 25 years, US tariffs had a more material impact on financial assets than economics, with equities and the dollar falling whilst gold, the euro and the yen rallied.
Where next for equities?
It is a common view amongst equity managers that relative to the yield earned on bonds, equities have been a more attractive asset class. However, with yields on 10-year US treasuries having risen from a low of 1.35% in mid-2016 to nearer 2.8% today, this argument has become less clear. What is more, the imbalances that have occurred during this cycle, driven in large part by the role of quantitative easing, make choosing where to invest in the equity market equally as vexing.
It all comes down to one’s perception of future growth and whether or not the years of easy monetary conditions through extremely low interest rates will lead inflation to break out of the c.2% target range.
At JH&P, we accept that we do not have a crystal ball. We have been modestly underweight equities this year and recently decided to increase portfolios’ cash cushions further.
Economic growth signals remain positive but financial market risks have risen and asset prices in both bonds and equities are high today compared to historical levels. It is at these moments that our thesis on each underlying asset/company must be tested most rigorously and our conviction assured.
If this conviction is lacking then this is the moment in the cycle when it can be better to hold more cash and wait and for a clear trend to emerge – better to be late and right than early and wrong.
Posted 16 March 2018
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