The rally in global equity markets, particularly in the U.S., during the first quarter of this year has been stunning. The move down and back up to current levels in the S&P 500, from the fourth quarter of 2018 through April 2019, represents an approximate 45% movement in equity prices over a five-month period. Did macro-economic conditions change that dramatically? Can the mere pause in Fed rate hikes below levels discounted in the market account for a 25% move up in equities from the lows? Have the markets become more fragile as an unintended consequence of bank regulations and the rise of algorithmic high-speed trading?
We believe that economic growth and the long running bull market are well supported by the following key factors: i) low and accommodative interest rates; ii) low and stable inflation; iii) continued strong corporate profits and entrepreneurial productivity; and iv) a reduction in regulatory burdens on the private sector. In short, the estimates for a sharp slow down in growth have not materialized. The runway for continued economic growth in this expansive cycle remains favorable. The key question is what is the length of that runway?
The sharp move down and back up in equity markets does get our attention. Much has changed since 2008. Most equity trades now occur digitally and do not flow through the books of market specialists whose responsibility is to help maintain orderly market prices. Low latency or high-speed algorithmic trading can generate momentum up or down and is now much more prevalent. Bank capital allocated for proprietary trading and market making of equities and bonds has also declined due to regulatory reforms. Finally, the growth of ETFs – now over two trillion dollars – and passive investing have injected another new dynamic into how markets react to market dislocation. Investors use ETFs to efficiently construct investment portfolios and allocate assets. These same products offer professional traders a convenient way to take on or lay off risk which can produce momentum in the price of underlying stocks and bonds.
As we potentially near the end of the current economic growth cycle, investors should assess the following trends. Currently, the macro economic picture suggests it is more likely than not that the long-anticipated end of this cycle remains in the future. How long is anyone’s guess, but with a Presidential election in 2020 and the possibility for good outcomes in trade negotiations with China, Mexico, Canada, and the EU combined with record projected low unemployment and continued economic relief from regulatory reform, there are plenty of arguments why economic growth will continue to support rising asset prices, particularly in U.S. and global equities.
The most daunting potential risk would be the failure of global central banks to meet their inflation targets with a miss to the downside; hence the risk of deflation with global interest rates still at record lows. Deflation, and the inability for central banks to lower rates enough to offset a fall in asset prices, could bring about an unexpectedly sharp recession, or worse.
Currently, the market is pricing in no interest rate hikes in 2019 with some observers, and our President, suggesting a rate cut is in order. If the economy can sustain growth consistent with the estimate of 1Q2019 growth, then the market might react with volatility, as it did in the fourth quarter of 2018, if rate increases return to the forecast in 2019. However, a corresponding continuation of corporate earnings consistent with ongoing GDP growth might dampen any fall in equity prices due to a rise in interest rates.
It is worth noting that during the 2000 – 2002 bear market, the U.S. equity market rallied four separate times by +20%. Again, we do not consider the most recent move up in equity prices to be a “bear market rally.” However, we believe the structural changes observed earlier have created an environment in which market moves can occur quickly and dramatically over short time horizons. In fact, the remaining life of the current economic cycle might be characterized by an overall move up in equities sprinkled with sharp periodic corrections based on a range of different triggers. In other words, the opposite of “bear market rallies” – “bull market sell-offs”- could be with us for a while until several key policy questions impacting the global economy (i.e. – global trade, Italy & the EU, etc.) are settled.
Brian Wesbury, the senior market strategist and economist for First Trust, calculates fair value in the S&P 500 index between 3,100 to 3,500 with 10-year Treasury yields at 3% or lower. The S&P 500 closed at 2,939.88 on Friday, April 26th with the yield on the 10-year Treasury at 2.5%.
Our advice has not changed. Steward your liquid investment assets by diversifying with an asset allocation constructed with an expected level of risk capable of generating annualized returns in the 5% – 8% range; but not so much risk that a market drop similar to 2008 could generate portfolio losses of – 40% to – 50%.