This equity market rally may be one of the most unloved of our time. Naysayers predicted this would be the summer of our discontent. However, world equities are buoyant, U.S. stocks have achieved new highs and volatility has fallen to near cycle lows. Even Brexit and the associated political instability in the UK—the fifth largest economy of the world—wasn’t enough to derail the ongoing economic expansion.
Three factors are working in our favor: the U.S. has limited exposure to the UK (just 3.1% of total trade), consumers are well supported (e.g., average hourly earnings growth of 2.6% year over year) and the manufacturing sector is recovering (e.g., the ISM Manufacturing PMI is at 52.6).
In order for this cycle to meet an untimely demise, we’d probably have to see a massive disruption in the U.S. or China—the largest economies of the world. That’s unlikely, given the current mix of accommodative monetary policies from their respective central banks. The other major central banks are also displaying their collective ability and willingness to support the expansion by keeping policy rates, borrowing costs and discount rates low. Indeed, global policy rates are the lowest they’ve been since 2002 at least.
Rudi Dornbusch, the late MIT economist, once said: “None of the U.S. expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve.” Ironically, the birth of the force (the Fed) that marked the beginning of the current regime of longer expansions also has the power to kill them. We hope that the Fed has learned this important lesson. The current expansion began in June 2009, and is well above the long-term average of 39 months. The longest cycle occurred from 1991 to 2001, a duration of 120 months (or 10 years), which is the one we need to beat. In our view, this cycle could ultimately prove to be the longest on record, sustained by low rates, disinflation and moderate real economic growth.
Brexit has a silver lining: it diminishes the likelihood of another disruptive Fed rate hike. At the start of the year, four rate hikes were priced into the federal funds futures market. Now, the market forecasts less than a 50% chance of even one more rate hike in December. The Fed has backed down, and global deflationary forces give the U.S. central bank cover to keep interest rates low for the foreseeable future.
Assessing the probabilities of economic expansions and recessions is a worthwhile pursuit because it helps equity investors gauge their potential upside and downside risks. Encouragingly, the yield curve—as expressed by the difference between 10- and 2-year U.S. Treasury bond yields—remains positively sloped. Furthermore, the longer dated yield curve—the difference between 30- and 20-year U.S. Treasury bond yields—has actually steepened. History shows that even when the curve inverted, recession was 1-3 years away. If the economy falls into recession, it would be the first time in 40 years that it has happened without an inverted yield curve. An inverted yield curve has always augured economic recession since 1976.
Although downside economic risks have increased, monetary policymakers should ensure that the global expansion continues, albeit at a slower pace. After all, worldwide economic recessions are rare, having occurred only 7% of the time since 1960, or in four of the last 55 years.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.