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A catalyst is needed for the least-loved bull market ever to end. We don’t see one on the horizon.
How It Ends (Spoiler Alert: We're Not There Yet)
This secular bull market—the least loved in memory—is now more than 100 months old, and up by 265% from its bottom on March 9, 2009. It is also the second longest bull market on record (after the 1990s’ dot-com boom) and fourth largest in terms of market advance.
For some investors, the sheer age of this cycle is enough to cause consternation. Yet there is nothing magical about the passage of time. As we have said time and again, bull markets do not die of old age. Like people, bull markets ultimately die when the system can no longer fight off maladies. In order for the cycle to end there needs to be a catalyst—either a major policy mistake or a significant economic disruption in one of the world’s major economies. In our view, neither appears to be in the offing.
For the first time since the 2008 financial crisis, the major economies of the world are expanding in unison. Over the past few years, these economies have taken turns experiencing sharp slowdowns in economic activity.
- 2012 - the European sovereign debt crisis.
- 2013 the U.S. slowdown from the fiscal cliff and sequestration
- 2014 Japan's ill-advised sales tax
- 2015-2016 The Chinese currency devaluation, capital flight out of emerging markets, and a sharp downturn in oil prices.
The world’s major economies are now growing at a reasonable clip. Global growth no longer needs massive policy support. Policy makers can still truncate this cycle with further monetary policy tightening, but the probability of that happening is falling as global inflation remains subdued. Growth will likely slow in the second half of the year (primarily as a result of the fading effects of the massive Chinese stimulus) and come down to a more sustainable pace. Nonetheless, we believe the cycle will last far longer than many imagine.
For all the hand-wringing over the political events of the past years, the U.S. financial markets have paid little attention. There have been brief bursts of volatility, as depicted in the chart by the Chicago Board Options Exchange S&P 500 Volatility Index (VIX), followed by continued advances. A single political event will likely not be the catalyst that ends this elongated cycle. Rather, political events will continue to mount—as bricks in the “wall of worry”—even as markets continue to climb. (Just ask the Europeans, who recently muddled through a make-or-break year for the Euro with little incident).
Don’t confuse political events with actual policy decisions. The markets did not take too kindly to the poorly-communicated August 2015 decision by the People’s Bank of China to devalue the currency; nor to the U.S. Federal Reserve’s (Fed’s) decision to raise interest rates a few months later. Rate-hiking is a blunt policy tool. We believe volatility will be sustained in the future when the Fed becomes more hawkish on inflation. For now, volatility, which had been the lowest on record, will likely briefly spike as (geo) political events unfold (the ongoing incident in North Korea for example) but will not be the catalysts to end the cycle.
Inflation has undershot the Fed’s target for 59 straight months, even as the unemployment rate has more than halved. The Phillips Curve, the supposed inverse relationship between the level of unemployment and the rate of inflation (see right chart), is proving to be flatter than in the past. The rationale as expressed by Federal Reserve Board governor Lael Brainard is that America’s labor market is not as strong, nor as tight, as the 4.4% unemployment rate suggests.
Case in point: The ratio of employment to the overall employment has risen to 60.1%, but remains below its pre-crisis peak of 64.6%. As more people returned to the work force, the rising participation rate has kept a lid on wages and will likely to continue to do so for the next few quarters. As depicted on the left chart, significant inflationary pressures are unlikely with minimal wage growth. With the average hourly earnings advancing over the past year by 2.5% and inflation by only 1.7%, the Fed is unlikely to raise interest rates again this year.
Bull markets historically end following a series of interest-rate hikes by the Fed, a flattening of the U.S. Treasury yield curve and ultimately an inverted curve. Currently the federal funds rate is at 1.25% while the 10-year U.S. Treasury rate has been hovering between 2.1% and 2.4% since the end of March. The yield curve is sufficiently steep to promote credit growth and extend the cycle.
Here’s the risk: The current macro backdrop—low unemployment, some wage growth, and a weaker U.S. dollar—is providing the Fed an opportunity to raise interest rates should it believe that it’s falling behind in its efforts to contain inflation. If the Fed were to raise the funds rate to the median projection of Federal Open Market Committee (FOMC) members by 2018 or 2019 without a coincident pickup in growth and/or inflation, then it’s likely that the yield curve could invert and the cycle could come to a premature close. We assign a low probability to this outcome for two reasons:
- Inflation remains benign and is unlikely to pick up in the coming quarters.
- The Fed is unlikely to invert the yield curve as policymakers turn their attention toward the prolonged unwinding of its balance sheet. There is no historical precedent, however, to guide the nation’s central bankers through this process. As a result, this policy represents a tail risk to the global economy. At a minimum, the U.S. savings rates will have to rise to offset the lack of Fed participation in bond markets. The Fed will likely be able to manage this process without undermining the ongoing economic expansion.
In the aftermath of the 2008 financial crisis, European policy makers provided a real-time experiment in what not to do when responding to a crisis. More recently, northern European countries backed off on their austerity demands on the weaker peripheral countries and ECB President Mario Draghi committed to doing whatever it takes to preserve the Euro. Wages and inflation subsequently rose across the continent. Credit and earnings growth followed suit.
The European Central Bank (ECB), having helped to bring the continent back from its disinflationary abyss, is now likely to begin scaling back its policy accommodations. Any policy tightening will probably be modest and gradual as secular forces—including aging demographics—are likely to keep inflation subdued, in our view.
The U.S. economy is not over-levered.
- The U.S. economy is not over-levered. Since the 2008 financial crisis, credit growth among households, financial corporations, and state and local municipalities has been virtually zero. Non-financial corporations in the United States have taken advantage of low interest rates and borrowed money, though not nearly at the same rate as in prior decades.
- The U.S. financial system is better capitalized than it has been in years. The Federal Deposit Insurance Corporation (FDIC) Tier 1 Risk Based Capital Ratio of all insured institutions is more than 13%, well above the levels of 2008 and the long-term average.
U.S. businesses have not gone on a spending binge. Private investment in infrastructure, equipment, and intellectual property as a percent of U.S. gross domestic product is still only modestly above the long-term average.
Business investment has been benign when compared with the late-1990s when the telecommunication companies began building networks in the sea, on land and in the air; or when many dot-com companies engaged in profligate spending such as on extravagant business facilities.
Investment has also not reached levels experienced leading up to the housing bubble that ultimately led to a financial crisis. In addition, mergers and acquisitions—in both total number and volume—are declining. The large number of high-profile, overpriced deals that are typical at the end of cycles have not come to pass.
In our view, by almost any valuation metric—price to book, price to sales, price to earnings, price to cash flow—U.S. equities are not cheap in relation to their historical average. Yet simply knowing that equities are trading at above-average valuations doesn’t provide much help to investors. There is virtually no statistical relationship between most valuations metrics and future returns over 1–3 years. For equities to not perform well over the next one- to three-years there would need to be a negative catalyst in the form of policy tightening or deteriorating economic conditions.
Importantly, U.S. equities are still cheap in relation to bonds. The S&P 500 Index’s earnings yield is 4.5%, compared to the 10-year U.S. Treasury rate of less than 2.5%. Simply put, S&P 500 companies earn more when compared with their current price than the interest earned on 10-year government bonds. Equities often trade at premiums to bonds because they tend to outperform bonds over most intermediate- and long-term periods. For all of the pundits’ concerns that the current environment is reminiscent of the late 1990s, we are reminded that at the end of 1999, the S&P 500 Index earnings yield was 3.41%, compared with a 10-year Treasury rate of 6.44%, for a spread of 3.03%. Back then, equities weren’t only more expensive than they are today—but also trading rich to bonds.
Investors have a tendency to overestimate the likelihood of events with greater availability in memory. Lately, they have been comparing the robust returns of a handful of U.S. growth stocks—primarily in the Internet retail, Internet software, and services industries—with the high-flying, overvalued technology stocks of the 1990s’ technology bubble. That comparison borders on hyperbole. In our view, for one, the failing companies of the early 2000s—such as Pets.com, Webvan.com, eToys.com, GeoCities.com, and Kozmo.com—do not bear any resemblance to companies such as Facebook, Apple, Amazon, Netflix and Google (collectively known as FAANG), which, in our opinion, have strong fundamentals and are disrupting multiple industries.
Even when compared to companies with sustainable business models such as Intel, Cisco, Microsoft, and Oracle, the so-called FAANG stocks are currently trading at significantly lower valuations on a price to sales basis than did those technology and telecom companies in 1999. Further, their relative performance isn’t even in the same ballpark. Starting with the inception of the FAANG group of stocks in June of 2012 (Facebook was the last to go public in May of 2012), and comparing them to the start of the cycle for their Tech Bubble counterparts (June 1992), the FAANG’s have underperformed by about 250% relative to the S&P 500 over the first 5 years (6/92 – 7/97 compared to 6/12 – 7/17).
Bull markets typically end following a prolonged, pronounced period of long-term equity outperformance to bonds—and with massive inflows into global equity mutual funds and exchange traded funds (ETFs).
Since the 2008 financial crisis, more than $1.28 trillion have flowed in bond strategies, while equity strategies have experienced $737 billion in outflows. If bull markets end with a euphoria about equities, then it’s hard to reason that the end is nigh.
The next market correction is unlikely to mark the end of this cycle. The chart above displays the series of rallies without 10% corrections that take place within secular bull markets.
Investors should not forego returns now because they believe that the next drawdown will ultimately be large. There is simply not enough leverage in the system to create a systemic sell-off of assets. Nor should investors forego returns simply because they believe that it’s been too long since the market experienced a meaningful correction.
The S&P 500 Index fell by more than 14%, peak to trough, from the middle of 2015 until February of 2016, ending a 666 day period without a 10% correction and a market advance of more than 50%.
- The latest advance has not had a 10% correction since February 2016. While it has been reasonably strong and sustained, its duration and magnitude pales in comparison with those of past rallies within long-term bull markets.
High yield bond spreads are relatively tight following a sharp rally from their February 2016 bottom. Historically, it is not uncommon for high yield bonds to trade at tight spreads for a prolonged period of time, including from 1994 to 1997 and from 2003 to 2007. In fact, since 1994, high yield bond spreads have been tighter than average 57% of the time.
The fundamentals of high yield bond issuers remain sound as many businesses have taken advantage of the low rate environment to lower their borrowing costs and extend their maturities. Relatively high interest coverage ratios and a limited number of near-term high yield bond maturities suggest that default rates are likely to remain low. The time for coupon-plus returns from high-yield bonds is likely behind us, but U.S. high-yield credit and senior loans remain attractive when compared with most other income alternatives in the United States.
When comparing the current economic environment with notable past recessions, we find that the classic telltale signs of excess are not evident.
- The Great Depression cannot be adequately accounted for by any single explanation, but in many ways it was a bank credit boom gone bust. Today, credit growth remains generally modest and the U.S. banking system is better capitalized now than it has been in a very long time.
- The late 1970s and early 1980s were characterized by a prolonged period of weak growth and high inflation. Today, inflationary pressures remain muted.
- The technology-driven bull market of the late 1990s resulted in excessive and unwarranted equity valuations. Today, valuations are modestly stretched but not to the extent they were in 1999. Equities are still cheap relative to bonds.
- The 2008 financial crisis was highlighted by a sharp rise in household debt as a percentage of personal income. Today, household balance sheets appear much more robust and less leveraged.
China is one of the few places in the world that has seen excess credit growth. As recently as 2008, China’s total credit to the private, non-financial sector was only modestly above 100% of the country’s gross domestic product. Since 2008, Chinese policy makers have sought to maintain relatively high levels of growth and have succeeded. Over that time, however, Chinese debt levels have surged while economic output has failed to keep up.
China will increasingly be faced with a growing array of non-performing loans in its financial system. Importantly a typical emerging market crisis (like that of Indonesia in 1998) is not looming. Commonly, emerging market crises result in massive capital flight and declines in local currencies of 20-25%.
For a big crisis to occur, there would need to be a funding crisis at the banks. But savings rates are high and money can’t readily leave the economy—two factors that make a funding crisis very unlikely. As a result, in our view, China has time to deal with the non-performing loans and the government will increasingly work with large debtors to extend their loans and restructure their interest burdens.
The upshot is a massive misallocation of capital that may ultimately lead to a slower growth rate in China though, importantly, not a global economic crisis.
The sharp deterioration in global trade that has plagued many of the world's emerging economies—China’s in particular—is over. Emerging economies are currently benefitting both from a pickup in economic activity in Europe and Japan and from renewed comparative trade advantages in the aftermath of the sharp declines in their currencies in 2015 and 2016.
The Fed's late-2015 rate hike came at a time when the average real yield in the emerging markets was close to zero, Chinese policy makers were confounding investors with their actions, and an oncoming wave of European elections threatened to unravel the European Union. By then the dollar had rallied by 30% amid massive capital flight from international markets into U.S. dollar-denominated assets. Emerging market growth slowed significantly, oil prices plummeted and U.S. multinational-companies entered an earnings recession. It all reversed course when the Fed backed off its tightening stance.
Since then, the dollar has weakened, and it will probably be relatively stable or weaker in the coming quarters with the Fed’s cautious stance on monetary tightening, with Europe exceeding growth expectations, and with emerging market real yields appearing more attractive.
A stronger dollar would be a potential sign for investors to proceed with greater caution—but such a scenario does not appear to be in the offing.
We are optimistic that this cycle will ultimately be the longest on record, though we do not believe our view is Pollyannaish. We will continue looking out for telltale signs indicating the end of the current cycle, even as we believe that none of them are forthcoming:
- A rise in U.S. and European inflation: If inflation picks up meaningfully in the developed world and tighter policy commences, then the cycle will likely be curtailed.
- A widening of high-yield credit spreads: The bond market is usually a good indicator of the end of a cycle. Cycles end with the yield curve inverting and high-yield credit spreads blowing out. An equity market sell-off typically follows soon thereafter.
- A declining 10-year U.S. Treasury rate: The 10-year Treasury rate will reflect the real growth and inflation expectations of bond market participants. A flattening yield curve driven by the decline of long-term rates would be an ominous sign for the U.S. and global economy.
- A strengthening U.S. dollar versus emerging-market currencies: A flight of capital from emerging markets to the United States would slow growth among the former—which are the main drivers of economic activity—and potentially cause another earnings recession for U.S. multinational companies.
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Chief Investment Officer, Portfolio Manager
Senior Investment Strategist
Investment Strategy Analyst
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