by Erik Ristuben, Russell Investments
This time is different.
Really.
I’m fully aware that the above phrase constitutes the four most dangerous words in our business. And, truth be told, on first glance, it may seem that today’s late-cycle bull market is no different from any others in recent history.
For starters, unemployment is low and the U.S. Federal Reserve (the Fed) believes that the economy is at full employment, and has subsequently raised rates to control the expected higher inflationary pressure that will arise from upward wage growth. In capital markets, equity valuations are high and credit spreads are narrow. These are all conditions (and actions) typically seen in the later stages of equity market, credit and economic cycles.
However, we believe the similarities end there. Why? There are two things that make this bull market—at this stage of the game—very different:
- The late-cycle fiscal stimulus of tax cuts and increased spending
- Tariffs
Could either of these factors cause the market cycle to progress in atypical fashion? In other words, will the rug of economic growth be pulled out from under us faster than usual? Could a bear market kick in sooner than later? Or can the fiscal stimulus forestall the next recession longer than expected?
Before I answer, it’s helpful to do a deep-dive into the two key differences that exist today.
Fiscal stimulus
Let’s start with the recently-passed U.S. fiscal stimulus package, which includes the tax cuts of late 2017 and the increased spending bill authorized by Congress in February. All told, this represents an unprecedented level of fiscal stimulus this late in an economic cycle. The package is roughly the same size as the Obama stimulus package in 2009—the difference being that back then, Congress enacted the American Recovery and Reinvestment Act to help pull the U.S. out of the Great Recession. In other words, it’s not the size of the current stimulus that’s unusual—it’s the timing. A fiscal stimulus package this late in the market cycle is very unusual, specifically when the Fed is engaging in tightening monetary policy.
Ultimately, the question for today’s market is: Does this fiscal stimulus package lead to an extension of the economic cycle, or will the increased economic activity resulting from it eat up the little remaining economic slack in the economy, pushing asset valuations up and hastening the next recession?
Our view at this point is that the next recession remains out of our 12-month forecasting horizon—but we suspect that it may be lurking not too far beyond. Why? We believe that any incremental increase in economic activity will likely create the inflationary pressure that the Fed is looking for—the central bank has identified 2% inflation as its target goal—allowing it to respond by increasing monetary tightening (via raising interest rates on a more frequent basis).
In turn, a more aggressive Fed will likely cause worry in financial markets, particularly the bond market. This is because conventional wisdom holds that most recessions are caused by an error in monetary policy. In this case, the mistake would likely be seen as the Fed being too aggressive in raising interest rates.
The likely outcome of all of this is that the U.S. Treasury yield curve will flatten and eventually invert. By this, I mean that on the short end of the yield curve, the 2-year Treasury yield will increase at a faster clip than the 10-year Treasury yield on the longer end of the curve. The point of yield curve inversion that we will be focusing on is when and if the 2-year yield becomes greater than the 10-year yield. Why? Typically, once this happens, equity markets slump and a recession follows in approximately 12 to 15 months.
In short, while the recently-enacted fiscal stimulus in the U.S. may lead to a sugar rush of economic activity, we don’t believe it will forestall a recession. As the above scenario shows, if anything, it may speed up the timeframe.
Tariffs
As recent months illustrate all too well, the stock market has been highly sensitive to tariffs and talk of trade wars—and there’s very good reason for this. Over the last century, the global economy has been heading toward free trade. For the last 40 years in particular, it’s been progressing to free trade virtually unabated. So, when the world’s largest economy starts talking of protectionism, this amounts to a potential major change. Change means different—and markets hate different. Different creates uncertainty, uncertainty creates indecision, and indecision can create inactivity. It is this that’s at the heart of the market’s skittishness.
An example might be in order. Let’s say you are a manufacturer with a product offering that contains a significant amount of steel. Your current supply chain includes countries whose exports into the U.S. are subject to the tariffs recently enacted by U.S. President Donald Trump. What do you do? Perhaps your initial thought is to pass the increase in costs along to your customers by raising prices. However, this may result in less demand for your product. In the end, your prices will likely go up and economic activity, at least for your business, will go down. It is these pressures that lead economists to view protectionism as stagflationary, meaning that the initial impact of tariffs leads to higher prices and a reduction in economic activity.
In their current form, we believe that the tariffs implemented by the U.S. do not rise to the level of a full-blown trade war. If the U.S. moves into an aggressive protectionist stance against China, that picture would change, and our dynamic CVS (Cycle, Value, and Sentiment) process would very likely drive us to downgrade our cycle scores to the point where an imminent recession and associated bear market would be likely.
To be clear, we do not expect this to happen—it’s not our central scenario—but we’ll remain very vigilant as this situation continues to evolve.
The wrap
The two key differences with this market cycle notwithstanding, we ultimately still expect things to play out in more or less typical fashion, with the Fed raising interest rates to combat emerging late-cycle inflation. Although we don’t see a recession as far out as next spring, we do expect the yield curve to invert as early as the end of this year. In the interim, we believe that the stock market will likely move forward and bonds will provide modest positive returns.
So, yes, it’s not your father’s market. But in the end, today’s bull market is still likely to wind down in much the same way.
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