We’re awaiting the outcome of what is now a four-month long consolidation of the stock market that began on January 26th. In our latest letter to clients we pronounced that the last stage of the correction began on April 2nd. Some experts are speculating that this consolidation will be a launching pad for the next leg of this lengthy bull market while others see it as a precursor to the end of the cycle. No doubt, there will be another recession and another bear market, but we don’t believe it’s imminent within the context of current economic conditions. Those conditions point to an extended expansion of the economy as a second wave of consumption follows full employment and the ascendance of the Industrial/Manufacturing sectors. For that reason, we see another advance upward as the probable next act for the market but would recommend it be approached with a degree of caution by some investors.
Debate Surrounds the Aftermath of the Correction
We subscribe to the simple maxim that performance of the markets generally correlates to that of the underlying economy. Of course, that correlation can vary to a wide degree but consistently, over the longer term, the stock market reflects an economy that is either expanding or contracting. The correlation usually weakens at the beginning and end of business cycles due to timing, making it challenging for investors to navigate through the end of a bull or bear market.
We’ve currently been enjoying the second-longest bull market on record, but one without the excesses of sentiment and valuation that usually precede the onset of recession and a bear market. We saw those excesses in 2000 with the dot.com frenzy and in 2008 with the commodity boom, the real estate bubble and the securities linked to it. Thankfully, we don’t see that same degree of optimism and reckless abandon in investors today. However, we’re on the lookout since it’s rare to see a bust, absent a boom.
This has been one of the most vilified bull markets in the modern era and we think that’s due to the lack of a “boom”. We’ve seen a long, low, upward trajectory of a recovering economy being supported only by monetary policy until last year. While many argue that we’re late in this cycle, there are some who say that last year’s newly crafted fiscal policy will serve as a launching pad for an extended expansion of the economy that could result in not only the longest bull market on record, but also one that will match the amplitude of prior record bull markets. If that proves to be the case, there’s more room to the upside for this market to advance.
We’ve often chided those who mistake noise for news in headlines warning of the next big disaster that will befall the economy and the market. Greece, Russia and the Ukraine, the Ebola outbreak, Brexit, and the 2016 Election are just several examples of “big” events that many predicted would sink the global economy and roil the markets as if it was a repeat of 2008. While that noise sent some investors to the sidelines, those that did have sellers regret. As we navigate through this last stage of what we think is a correction, we thought it would be the appropriate time to review the current headlines and determine which, if any, will have a longer-term negative effect on the economy and its markets.
Risks to Expansion
Among the items considered: The Fed, interest rates and the bond market. A looming trade war. A slowing Europe and the global economy. All of the above provide grist for the media to dramatize. Keep in mind that bad news is good news for the media in that it boosts ratings and makes viewers afraid to change the channel. We encourage investors to rely on actual data and seek out balanced and objective sources of information for their analysis. We’ll try to provide that here.
The Fed: It’s well documented that rising interest rates act as a headwind for the economy and the stock market. The Fed has ended QE (Easing) and begun QT (Tightening) by strategically offloading treasury bonds from its balance sheet. That means more supply coming into the market. Thankfully, that has been absorbed by increased foreign demand for treasuries as the EU slows and Italy experiences banking instability. The Fed, at the same time, is normalizing key rates. Both can dissuade bond buyers and may require higher rates to attract them. Our expectations for benign inflation, as a result of QT, lead us to believe that the Fed will follow improving economic data rather than lead in an attempt to preempt the return of inflation and risk smothering the current expansion. We expect the rate of change in interest rates to be benign but that view could change as the story unfolds in the next year. Minimal Risk
Trade War: At present, US tariffs have triggered some retaliation from our allies and trading partners. We view this as mostly posturing on both sides and part of the negotiating process to redraw the lines on the playing field of global trade. We believe a deal will ultimately be struck but not without some drama. There is the potential for the US to leave the table and let the chips fall where they may. This could weigh on the US export market and negatively impact the current Industrial/Manufacturing expansion along with earnings of some larger multinational companies. This presents the most proximate risk to the market. A worst-case outcome here could trigger a short-lived market reaction or, more likely, an overreaction. Moderate Risk
Europe and the Global Economy: While the EU is contemplating an end to Quantitative Easing, Italy and Spain have embarked on a divergent path away from fiscal discipline. This casts doubt on the continuation of a synchronized global expansion as GDP growth in the EU slows. The US economic recovery didn’t appear to be dependent on Europe in the past so, with new fiscal policy stimulus in place, we’re still likely to see improved US GDP growth in spite of the EU’s problems. Low Risk
In summary, these appear to be the most proximate threats to the continued expansion of the US economy. The first two hold the potential to negatively impact the expansion and the markets in the long-term. An extreme outcome for the Fed would be a collapse of demand for US treasuries courtesy of the bond vigilantes. A full-blown trade war could occur if no one at the negotiating table blinks. Either could quickly erode both business and consumer confidence and lower expectations for corporate profits. The effect on the markets would be predictable. In our view, this is an improbable outcome and not a reason for risk-tolerant investors to be bearish and change their approach. For investors who view themselves as having moderate to low risk tolerance and don’t mind leaving some returns on the table, it’s the perfect time to revisit objectives and liquidity needs to determine if minor changes to current asset allocations are appropriate now while conditions are favorable.
Conway • Jarvis LLC