13 February 2018

In my 2018 Investment Strategy blog entitled “Aging Rally or More to Play For?“, I indicated that while the US (and global) equity market rally was aging in calendar terms, the factors traditionally signalling the end of the cycle were not yet evident.  Nevertheless, I suggested that the US market would experience increasing volatility, and produce only low, single-digit returns this year, with most of these gains in the first half of the year.

Stock market rallies do not die of old age.  Rather,  two factors traditionally spell the end of equity bull markets: rising inflation (often along with a surge in capital spending eventually resulting in over-capacity) and policy mistakes (normally when central banks tighten monetary policy too much in an attempt to curb inflation).  At this stage, the recent slump in equity markets would best be described as an overdue correction, as the low volatility and uninterrupted 2017 rally was highly unusual.  However, both of these traditional precursors to the end of bull markets have become increasingly evident already this year.  And, while it may be a bit premature to suggest that the market has peaked,  I am increasingly convinced returns through the end of 2019 will remain modest.

Inflation Risk:  Cyclical Risks Building

In earlier essays, I pointed out that the as the US recovery is more advanced than in the rest of the world, the United States confronts more inflation risk than elsewhere.  Figure 1 shows that the Employment Cost Index — the most comprehensive measure of wages (the key factor in inflation) — has been rising modestly, but steadily during the past two years  — reaching 2.6% in Q4 2017.   In addition, the January labour market report indicated that wage pressures continued to build in 2018, as average hourly earnings advanced further reaching 2.9%.  The Philips Curve appears relevant again:  low unemployment is leading to higher wages.

With the US economy still growing at an above-trend rate, wage and price pressures are likely to continue to emerge. For perspective, it is worth noting that wage inflation remains below the level prior to the 2008 recession.  However, the gap is narrowing. And, wage growth in excess of 3% would put the Federal Reserve’s 2% inflation target at risk.

Risk of Policy Mistake Rising

With US unemployment low, America’s  adoption of a more stimulative fiscal policy is ill-timed, and will add to these building cyclical inflation risks.  More importantly, recent budgetary decisions create an environment in which policy mistakes are more likely to occur.

The combination of last year’s tax reform and the recent decision to increase Federal government spending by $400 billion during the next two years will increase the budget deficit to nearly 6% of GDP in 2019 (compared to 3% of GDP this year). Even before these policy decisions, the CBO estimated that US Federal debt would rise from 77% to 90% of GDP during the next decade. In the absence of future belt-tightening, the debt ratio is now likely to exceed 100% of GDP by 2027 (Figure 2).

These debt dynamics will have several important implications.  First, of all, the promised infrastructure plan is likely to be more modest than needed.  Already, the Trump Administration is limiting the Federal government’s contribution to the much heralded $1 trillion program to $200 billion.  In addition, the experience of other countries — Japan and Italy for example — illustrate that debt at these levels eventually limits the economy’s long-term growth potential.  Furthermore, the prospect of larger deficits (especially at a time when QE is ending) is already leading to higher long-term bond yields.

If fiscal stimulus adds to inflationary risks, the Federal Reserve is likely to tighten monetary policy more than planned.  The market has now discounted the three rate hikes the Fed has announced for this year, but I expect the Fed will raise rates 4 times in 2018. In addition, the market anticipates only one additional hike in 2019, leaving the Fed funds rate 50bp below the Fed’s projected long-term target.  The market will eventually need to adjust to the likelihood of additional Fed tightening next year.  The March FOMC meeting will be important: will the Fed signal more than three hikes in 2018, and will fiscal expansion cause the Fed to raise its projection for the long-term Federal funds rate beyond 2.75%?  Watch the dots!

With overheating being the immediate risk, it may seem premature to worry about recessionary risks.  However, ill-timed fiscal stimulus puts the burden of controlling inflation fully on the Federal Reserve.  Under these conditions, policy errors can occur.  While still unlikely at this stage, the market may need to consider eventually the possibility of recession in 2020 or 2021.

Stocks Versus Bonds: Beyond the Tipping Point

In my 2018 Investment Strategy, I indicated that while US stock valuations were expensive on all traditional measures except when compared to bond yields.  As a result, equity markets had proven immune to tighter Fed policy and rising interest rates in recent years.  However, I suggested that a tipping point would be reached as US 10-year yields approached 3%.  Likewise, equity markets would become more volatile as the Fed funds rate approached 2% — becoming positive in real terms.

The following useful Chart from Morgan Stanley illustrates why markets now have reached this tipping point.  At the stock market’s January peak, equities were trading at 18X 2018 projected earnings (in other words, the earnings yield was 5.5%). As US bond rose towards 3%, the equity risk premium shrank toward 250bp, bringing the premium roughly in line with its long-term average.

In other words, for the first time in years, equities were no longer cheap compared to bonds! In the future, therefore, as US bond yields rise, the stock market’s P/E ratio will decline!! As an example, if US bond yields were to rise to 3.5%, the stock market P/E ratio would need to contract to 16.5X — putting the S&P 500 at 2550 compared to its January peak of 2850 — in order maintain the risk premium near its long-term average level.

As the Chart illustrates, the ERP can vary widely.  Investors should consider the correct combination of P/E, bond yields, and risk premium.  When establishing my 2018 year-end target of 2700, I assumed a 17.5X market P/E, 3% bond yields, and 275bp ERP.  With inflation and policy risks likely to grow, I anticipate equities will remain cheap relative to bonds.  However, as bond yields are likely to rise to 3.25 to 3.5% during the next 18-24 months, P/E ratios are likely to remain around 16.5X earnings in 2019.  Under such circumstances, this model suggests the S&P 500 may struggle to sustain levels meaningfully above 2700 during this interval.

Strategic Implications

• Rising inflation, interest rate, and policy risks will add to equity market volatility.  The recent market slump, however, is likely to prove to be an overdue correction, rather than the beginning of a bear market at this stage.
• Equities are no longer dramatically cheap compared to bonds. Further increases in bond yields will hit P/E ratios, and cap stock market advances.  In other words, returns on bonds and equities will become more positively correlated than in recent years.
• US equity markets will produce modest, low single-digit returns in the period ahead.
• While overheating is the concern near term, markets may need to consider 2020/21 recessionary risks at some stage.