Investments - Markets

Taking Stock of the Aging Bull Market

Hans Olsen

By Hans F. Olsen, CFA

Chief Investment Officer

October 1, 2018

“Can it get much better?” This is the prevailing question I hear from investors as they attempt to discern where we stand in this market and economic cycle. Judging from a broad set of economic data, the answer might be “not likely.” The third quarter was again marked by rising employment and wage growth, near-record levels of consumer and business confidence, accelerating GDP growth, and gravity-defying corporate profits, all against the backdrop of gently rising interest rates.

The Economy

Indeed, the economy’s stars have aligned to create an idyllic macro environment not seen in a generation. For the understandable eye rolling this assertion provokes, consider the following:

  • The economy has reached the highest level of small business optimism since the National Federation of Business began measuring it in the early 1970s.
  • Business owners with unfilled positions hit an all-time high, and a record 25 percent of owners cited finding qualified workers as their single most important business problem.1
  • Consumer confidence is at its highest level since September 2000.2
  • The unemployed-to-open jobs ratio is at its lowest level in the past 15 years, and this year wage growth increased at its fastest pace since 2009.3

These are hallmarks of an economy firing on all cylinders. Remarkably, this state of play is unfolding not at the beginning of an economic expansion, but nearly a decade after the cycle began. Moreover, the late-stage acceleration comes in the midst of systemic disruption to the structure of the economic and security order established under the 1940s Bretton Woods accords.

To understand this economic boom, one must look at the bust that preceded it.4 The Great Recession was precipitated by a financial crisis the likes of which had not been seen since the banking panic of the early 1930s—a principal cause, along with a trade war, of the Great Depression. Economic disruptions instigated by financial crises are fundamentally different from the normal cyclical recessions that are a feature of the business cycle. Because credit is the lifeblood of commerce, when the financial system becomes imperiled and credit ceases to flow, the economy develops the equivalent of sepsis. This, to be sure, is a potentially fatal condition. Recovery from financial crises, especially a systemic one like the late 2000s global financial crisis, take longer than a recovery from the typical recession caused by the inevitable malinvestment that occurs in a business cycle’s later stages.5

The nature of the 2008 bust and its related policy responses appear to have elongated this recovery and ongoing expansion. Serial quantitative easing programs by global central banks and the avalanche of regulation helped to respectively smooth and hinder economic recovery. Regulatory rollback accompanied by aligning U.S. corporate tax rates with the OECD average has given American companies a shot of tonic that reinvigorated commercial activity years into the expansion.

Interest Rates

Whether by design or luck, the quickening pace of growth comes at an opportune time, as interest rate normalization is set to ratchet up. Short-term interest rates continue their trek higher and expectations of another rate hike before the end of the year appear to be spot on. Of the two principal levers that monetary leaders can pull—short-term interest rates and balance sheet size—the latter is likely more important.

The impact of rising interest rates—and the attendant pull it is having on the dollar—is manifesting itself clearly on performance in emerging markets. Both equity and fixed income returns in the emerging world are negative so far this year. Moreover, concern is growing over emerging market companies’ ability to service and finance their dollar-denominated debt. Issuance of hard currency debt is running at a fraction of prior flotations.6

If the Federal Reserve delivers an additional rate hike as anticipated, 2018 will be the year in which the price of money finally achieves a level of normalcy. Short-term interest rates have historically traded near the inflation rate and the recent hike, along with the expected one, will place the Federal Funds target rate between 2.25% and 2.5%. This is in line with the headline inflation rate reading of the Consumer Price Index (Exhibit A).

Exhibit A - Consumer Price Index GrowthMost revealing in the inflation picture is how quickly it has manifested itself. Inflation talk was almost non-existent in 2015. Concerns about deflation and the threat of policy normalization held the attentions of the financial “smart set,” while trepidations about inflation were deeply unfashionable. Yet in finance, as in fashion, all things are cyclical. The cycle now unfolding should usher in higher prices on both goods and money.

Fixed Income

Fixed income returns have been hobbled by the Federal Reserve’s policy normalization. The axiomatic relationship between interest rates and bond prices is in full effect this year. Moreover, the gravitational pull interest rates have on currency is becoming obvious: emerging market currencies have been battered amid the dollar’s rise over the course of the year, helping push emerging market equities into a proper bear market (Exhibit B).Exhibit B - Emerging Markets Performance

Domestic and Foreign Equities

This is not a market in which success stems from just showing up. Returns across the asset classes we follow present the picture of bifurcation (Exhibit C). U.S. equities are the best performing asset class by far, followed by high-yield bonds and cash. Investment-grade debt, commodities, government bonds, and international stocks of both the developed and emerging varieties have sported losses so far this year. The pattern of returns represents a stark contrast to the trends at this point last year, in which success was a function of just having money in any market.U.S. equities are undoubtedly benefiting from red-hot earnings growth, a strong domestic economy, and favorable tax and regulatory changes. Meanwhile, on the international front, developed market equity returns have been hindered by a cocktail of domestic challenges, including less-than-robust growth, European Union political problems, continued Brexit anxieties, and unsettling questions concerning trade.

Looking Ahead

The question, however, remains: “Can it get much better?” From the perspective of U.S. investors, in the short term the answer is, “yes.” The impact of corporate and individual tax cuts combined with regulatory relief has helped refresh the business cycle. U.S. corporate earnings should continue to benefit from these trends through the end of the year. Earnings comparisons next year, however, will likely become more difficult as the benefit from lower taxes is annualized in the flow of profits.

As interest rates rise, it is hard to visualize relief for fixed income and international investors. Furthermore, as the dollar wends its way higher, it will hinder international returns. When the world’s reserve currency of choice is expensive, it creates and magnifies problems for those who borrowed in that currency.

The odds that investors will suffer an autumnal bout of volatility are rising considerably. Interest rate hikes and escalating trade conflicts with China, the E.U., and Canada are all real threats that could tarnish the glow hovering over the U.S. equity market. The uncomfortable chance that stresses in the emerging world spread to developed markets is also beginning to catch discerning investors’ attention. While possible in 2018, this is more likely a problem for next year.

Overall, the landscape remains quite positive for investors who have positioned their portfolios for the current conditions. This aging expansion and bull market against the backdrop of monetary normalization, however, presents a picture of the economy and market moving along the business cycle’s ridgeline. While not at the peak, investors appear to be enjoying most of the vista offered by the summit.Exhibit D - Fiduciary Trust Asset Class Perspectives

NFIB Small Business Economic Trends, William C. Dunkelberg and Holly Wade, July 2018

Conference Board Consumer Confidence, SA, August 2018 via Bloomberg

U.S. Average Hourly Earnings All Employees Total Private Yearly Percentage Change, SA, via Bloomberg

Borrowing a line from the nonpareil economic watcher James Grant, editor of the eponymous Grant’s Interest Rate Observer

Carmen M. Reinhart and Kenneth S. Rogoff wrote the definitive work on this phenomenon in their book, This Time is Different: Eight Centuries of Financial Folly

The Wall Street Journal

The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.

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