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This time it's the same: equities and the business cycle

This time it's the same: equities and the business cycle

October 2017

Luca Paolini, Chief Strategist

Many investors believe that the business cycle is broken somehow. But it's not, and therefore the outlook for equities remains bright.

It’s too early to worry about a bear market for stocks. We think there’s scope for equities to keep climbing from here, and it's all down to the longevity of the business cycle.

Ours seems to be a minority view. While most investors agree with us that business conditions are buoyant, many fear that certain characteristics of the current upswing leave the economy vulnerable to a sharp and sudden reversal if interest rates rise further, dragging equity markets down along the way.

The bears contend that a backdrop of low inflation, anaemic bank lending and business investment, and a heavy reliance on extraordinary monetary stimulus make it more likely that the economy will experience an abrupt shift from expansion to contraction once policymakers tighten the monetary reins.

On closer inspection, however, this business cycle is really not that different from its predecessors.

keeping up with the economic cycle

US equity returns in excess of bonds compared with US jobless claims


Source: Datastream. Data as of  17.10.2017

First, consumer price inflation is no lower than in the late 1990s and is firmly within a multi-decade range. Nor is wage growth unusually subdued. For instance, US Federal Reserve estimates suggest US median wage inflation is in line with employment and, at 4.2 per cent, is where it was in 1999 and 2006. That indicates that more jobs growth should lead to further wage gains.

Second, US bank lending has been solid. Corporate lending has been growing at 4.6 per cent, only slightly below a previous cycle average of 5.8 per cent, and is above trend once inflation is taken into account. Meanwhile, annualised investment growth of 7.3 per cent is in line with what was seen during the previous three economic recoveries.

Third, the equity market rally is being fuelled by strong corporate profitability. True, quantitative easing has helped – we estimate it has depressed US bond yields by some 100 basis points, giving around a 15 to 20 per cent boost to the S and P 500. But both earnings and profit margins are at record levels, with the former accounting for more than 40 per cent of the S and P’s total return since 2009, according to our calculations. And yield spreads on high yield bonds aren’t historically narrow just because of central bank debt purchases, but also because default rates are at a record low.

Lower trend growth not a hurdle

What is unusual is that global economic growth is definitely weaker than the historical trend – a nominal 3.7 per cent per year over this cycle against 6.2 per cent in the previous one. But this is a structural phenomenon and reflects a multi-decade downward trend – the Fed and the IMF estimate that US trend growth has fallen from a yearly 2 per cent to around 1.5 per cent.

It is also true that central bank policy is still exceptionally loose. And notwithstanding the big rise in share prices, investors have had an extraordinary appetite for bonds throughout the cycle, while being much less enthusiastic about equities than in past cycles.

But broadly speaking, most factors support the case that this is a fairly normal business cycle, it’s just a bit longer than usual. Which is important because stock markets tend to slump only when the cycle ends and recession looms – and there are no compelling arguments for an impending downturn.

For example, in the US, there are no private sector imbalances – neither consumers nor firms are over-leveraged. True, the Fed’s balance sheet has ballooned and shrinking it could be a problem. But the central bank’s power to print money means that this won’t be an issue for the markets unless it makes a mistake and tightens policy too quickly. The typical business cycle ends when boom times result in a big rise in investment followed by overcapacity, falling profits and tighter policy.

That’s key to the outlook for equities and represents their biggest risk. 

interest rate headroom

Real adjusted Fed funds rate relative to US real GDP growth

Source: Datastream. Data as of 17.10.2017

For the first time since 2008, the US has a positive real policy rate. The real rate bottomed at minus 4.6 per cent in May 2014, adjusting for QE; the rise since is in line with the 4.5 per cent average increase in real rates during the last six tightening cycles. That looks like a warning sign for the markets - in four of those six episodes, a recession followed within a year.

However, we would point out that the real policy rate has always peaked above the US’s underlying trend growth rate. From this vantage point, the Fed could raise real rates by as much as 150 basis points from current levels – or it could shrink its balance sheet by around USD2 trillion – before provoking a major market correction or a bear market.

For now, there’s a low probability of recession, notwithstanding a few signs of stress, such as in the auto loans market. To us, this suggests this bull market has a way to run.  There’s a good chance that, encouraged by a robust economy and low volatility, investors finally rush to equities having favoured bonds since the great financial crisis – as they tend to do in the last stages of a booming market. Investors should recognise the opportunity cost of bailing out of the stock market too soon.