“Bull markets are born in pessimism, grow in scepticism, mature in optimism, and die in euphoria.”
– Sir John Templeton
Despite some recent wobbles, we’re in the midst of one of the longest bull markets in history. In fact, by some estimates, the U.S. bull market is just six months away from being the longest bull market in history.
But all good things must eventually come to an end.
And the correction we saw in early February, when most major stock markets retreated around 10 percent from their January highs, had many investors questioning whether we had reached the end of the line.
But as the brief nature of that correction suggests… I don’t think we have. All things considered, I believe that Sir John Templeton’s quote above is spot on. Equity markets have been in the “mature in optimism” phase rather than in a “euphoria” phase. And at this stage, I believe the U.S. economy isn’t on the brink of a recession just yet.
Let me explain…
Why the recent correction was just a hiccup
The fingers of blame for the recent correction a few weeks ago are being pointed at two causes…
The first is the stronger than expected jobs report published in the first week of February. The most important data point was that average hourly earnings in the U.S. had accelerated from a 2.7 percent growth rate to a 2.9 percent rate. This data immediately raised the possibility that inflation could be primed to take off, prompting the risk of a faster and greater rise in interest rates than the market has been expecting. (We wrote recently that investors should look at shortening their bond portfolio duration.)
The prospect of three rate hikes this year is pretty much baked into the financial cakes… that is, it’s what investors are expecting at this point. But this data point raises the possibility that rising inflation prospects will force the Fed to raise rates by much more than the current consensus expects. (As I’ll explain later, I think this is premature.)
That raises fears of higher costs for companies, risks to corporate earnings and a potential pullback of investment. It also suggests a slowdown in consumer spending and reduced aggregate demand. All of this points to slower economic growth and earnings growth… possibly even the prospect of a new recession.
The second finger of blame has been pointed at bets that short volatility. This has been a popular bet for many months as the U.S. market has been stuck in a very low range of volatility for a considerable time. The short volatility bet has been a useful hedge for some portfolios and viewed as an outright money maker by others.
A lot of people have said that that shorting volatility is a crowded trade (that is, there is a lot of money riding on it), and more importantly, that when volatility picks up again – as it has recently – it will lead to apocalyptic contagion effects in the wider markets.
Certainly, holders of short positions saw big losses when volatility rose. Tama recently wrote about just how bad those bets against volatility turned out for complex structured ETF investors.
But the claim of widespread contagion impacts from the short volatility trade was off base. Yes, short interest in the VIX (which is a popular index used for measuring the S&P 500’s volatility) rose through 2016 and 2017. But the total volume of short interest in dollar terms has been small in the overall scheme of things. At Q3 last year, the total short interest in the XIV and SVXY was a modest US$2.55 billion.
Some estimates suggest that had risen to around US$4 billion. Again, still a lot of money to lose, but in the context of the overall U.S. market, the scale is tiny. And the losses are confined to that particular trade.
So is the extended period of record low volatility over? Probably. But does a return to more historical volatility levels mean a calamitous bear market is the inevitable outcome? No. Equity markets in the past have typically done fine in periods of “normal” volatility.
But the jobs report and volatility aren’t the only reasons people think the bull market is nearing the end…
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Is inflation about to rise rapidly?
Some investors have also pointed to the rise in yields that has taken place in U.S. 10-year treasuries as an indication that inflation expectations have risen – with further upside in rates on the horizon.
But it’s worth noting that rates at the short end of the yield curve have risen by a similar amount. So the yield curve remains relatively flat. That is normally a signal that growth and inflation expectations are modest, with the risks tilted towards a growth slowdown rather than an acceleration of growth.
So at this stage, the U.S. economy is far from a recession, though the bond markets seem to be telling us to expect a slowdown in the coming year or two.
The tightening unemployment conditions in the U.S. are also seen by some as a signal of increasing inflation pressure risks and faster rate hikes by the Fed. But this data point is not as clear cut as it at first appears.
For example, while the official unemployment rate may be low, a lot of people are simply not in the labour market. The labour force participation rate, at 62.7 percent, is bumping along close to the 40-year record low of 62.3 percent, and well below the high of 67 percent back in 2000/2001. This is suggesting that there is still slack in the labour market.
And while we are on the subject of inflation pressures, there are good reasons to suspect that these pressures are not building strongly.
Looking at consumption
Consumption comprises approximately two-thirds of the U.S. economy. A rapid expansion of consumption could boost inflation. But there are limits to how much consumption can increase. Consumers can boost consumption in three ways – from higher wages, from running down savings and from taking on more debt.
First, there is some evidence of increasing incomes. But this is applying to a small part of the available labour force, and the rise in incomes is very modest. It is certainly not rising rapidly.
Second, the household savings rate is now close to a record low level in the U.S., having fallen from its post-global financial crisis recovery peak of 7.6 percent to around 3.6 percent. There is limited scope to boost consumption from savings.
Third, yes, consumers can take on more debt. But household debt has been growing rapidly in the past three years and now stands at US$280 billion higher than the 2008 peak. It has grown 16.2 percent since the 2013 trough and at last count was growing at almost 4.9 percent. Mortgage debt delinquency rates have been improving. But meanwhile, there has been strong growth in both student loan debt (now around US$1.4 trillion) and auto loans (now around US$1.2 trillion). And in both cases, delinquency rates are ticking up with about 11.2 percent of student loans and 4 percent of auto loans now 90+ days delinquent.
I have to wonder how much further household debt can go, and how much of a force this can be on consumption and inflation prospects in the coming year or so.
So it seems that rapidly rising interest rates caused by rapidly rising inflation isn’t a likely outcome right now.
But what about supply? By this I mean a possible flood of government bonds issued that could push rates higher. The Trump administration’s tax and infrastructure plans will be a stimulus to the economy (if they happen as planned) – but will be funded largely by debt. Government debt could rise by around US$1.5 trillion, from around 78 percent of GDP today to around 83 percent by 2020, according to provisional figures from the Congressional Budget Office.
A torrent of new debt coming to the market, or even the threat of this, may push interest rates higher than would be justified simply by current inflation expectations. This in turn raises the prospect of a new slowdown and the risk of a recession in the coming 12 to 24 months.
That is probably the bigger medium-term risk to equities than the job and wage numbers are. But again, this risk is over the next 12 to 24 months. Not right now.
So, to sum up, the markets have been comfortable in a mature optimism. And there has been little sign of the mania that preceded most other crashes in recent stock market history. But watch out for any euphoria… that’s when it’s time to worry.