With US wage inflation having paused and leading indicators turning back up, it appears the Goldilocks economy and the bull market in stocks may have further to go.
Stocks continued to climb in the third quarter with the S&P 500 gaining 4.5% for the period. This pushed the market’s gain for the first nine months of the year to 14.2%, quite a healthy showing. Of course, where you were in the market made all the difference.
If you had bought just the tech sector, for example, your stocks would be up 27% this year. But if you owned only energy stocks, you actually would be down 7%. If you were invested in the more cyclical parts of the market, you gained 8% while the less cyclical, more growth-oriented stocks gained 20%. Why the difference?
As we wrote about last quarter, the market in 2017 has been rather schizophrenic. While the headline gains for stocks as a whole suggest a healthy economy ahead (stock prices are, after all, economic forecasts), the internal makeup of the market suggests otherwise. When cyclical sectors like energy lag and less-cyclical, more growth-oriented sectors like tech lead, it suggests that the market sees economic growth slowing.
Global Growth and the Dollar
Another somewhat schizophrenic feature of the markets this year is a result of the stark divergence between US economic prospects and those of foreign economies. While leading indicators of US economic growth were fairly soft for most of 2017, leading indicators of global growth have strengthened, particularly in the Eurozone and Japan. This is unusual as the US is such a powerful trading partner with the rest of the world. Generally, if US prospects are softening, so are those of all the countries that export to the US. But this year has been markedly different.
As over 40% of the total revenues of the companies in the S&P 500 come from abroad, the S&P 500 is effectively a global stock index. The strength seen abroad this year has buoyed the shares of US firms that sell into foreign markets, despite a softening outlook for the US.
Stronger growth abroad also makes for a weaker US dollar and, indeed, this year the dollar has fallen against almost every foreign currency. A weak dollar translates into higher profits for US firms selling abroad, as those sales are made in foreign currencies and then converted into US dollars. Strength in foreign currencies means more US dollar earnings per unit of foreign sales.
So, this divergence in US and foreign growth prospects has also contributed to very mixed signals from the market. Shares of companies whose revenues come primarily from the US were penalized for the US economy’s softening outlook. Shares in companies with a lot of foreign revenues, on the other hand, were bid up due to the improving outlook abroad and beneficial currency translation effects.
Party Like It’s 1999?
Mixed signals or not, the market has continued to rise. Indeed, US stocks haven’t suffered a true bear market since 2008-2009. After bottoming in March of 2009, the US stock market has risen for 103 months without a 20% decline. The only longer bull market in the post-WWII era lasted 113 months from October 1990 to March 2000.
There are important parallels between the current market and the great bull market of the 1990s. In both periods, stocks climbed for so long because of a very long global economic expansion that produced little to no inflation. They both enjoyed “Goldilocks” economic conditions that were neither too hot, nor too cold.
But bull markets do not die of old age. They typically die because central banks–e.g., the Federal Reserve–raise interest rates to quell rising inflation produced by an overheating economy. This puts the brakes on the economy and the stock market. Absent inflation, however, the Fed has little incentive to aggressively raise rates and this allows stocks to climb further.
While bull markets don’t die of old age, there’s no denying this one is old, as is the economic expansion driving it. One indication the expansion is in its later stages is the US employment picture. With eight years of job growth behind us, the US unemployment rate has fallen to 4.2%, its lowest level since 2001. Nancy Lazar, our favorite Wall Street economist, projects it will fall to 3.7% by the end of next year—the lowest since 1969.
Tight labor markets mark the late stages of an economic expansion because they tend to produce wage inflation. (When the supply of labor shrinks, prices for labor go up.) Rising wage inflation makes the Fed nervous about inflation, in general, and a more aggressive tightening of the Fed’s monetary policy (higher rates) typically follows. This is how bull markets die.
Late last year and early this year, it appeared to us that we might be in the eighth or ninth inning of this expansion. Unemployment was very low. Early signs of wage inflation had appeared. The Fed had started raising interest rates. And leading indicators of the economy were softening. We took these as signs of trouble ahead and took defensive measures to protect your assets.
But then a funny thing happened. The game went into extra innings.
First, wage growth unexpectedly stalled in 2017, easing inflation pressures. Second, leading indicators of the economy recovered and rose to new highs in September. The former took pressure off the Fed to more aggressively raise rates while the latter suggested the expansion had caught a second wind. It looked like we might be heading back to the land of Goldilocks.
What We Missed
As readers of our Outlook pieces know, we’ve been fairly negative on the US economy and stock market all year. We were cautious, in part, because we saw the outlook dimming for the US economy. We also assumed, wrongly it turns out, that this would translate into a dimming outlook for foreign economies that export to the US—which is almost all of them. As noted above, this is the typical pattern historically. But this time was different.
Instead, we saw real strength in the Eurozone and Japan as prospects in the US softened. While the causes of this decoupling of Europe and Japan from the US are complex, they basically derive from the timing of each economy’s recovery from the Great Recession. The US was first to (finally) emerge from the Great Recession and so is further along in its business cycle compared to Europe and Japan. Think of it as the US showing signs of (cyclical) age while Europe and Japan have a bit more spring in their (cyclical) step.
This foreign strength is feeding back into the US economy by way of improved exports, which recently caused leading indicators of the US economy to turn back up. With wage inflation in the US having also paused, it looks like the US economy and the bull market in stocks may have further to go than we previously thought.
What We’re Doing
In retrospect, our portfolios have been more defensively positioned in terms of equity exposure this year than we’d like. We’ve always said that when we take defensive measures to protect your assets, we see it sort of like taking out an insurance policy. We can’t be sure we’ll need it and we that hope we don’t. But if it turns out we do, we’ll be glad to have it.
We took these defensive measures for two reasons: our dimming economic outlook and the heightened “tail risk” posed by a Trump presidency. At this point, we remain deeply concerned about the erratic behavior of the Trump White House. We are also still convinced that we are in the later innings of both the current economic expansion and the bull market in stocks.
That said, we believe there are more innings to go than we previously thought, so we’re notching up our equity exposure a bit. Portfolios will remain defensively positioned, but a bit less so than previously.
Farnum Brown, Chief Strategist
The opinions expressed herein are those of Arjuna Capital, LLC (“Arjuna Capital”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. Arjuna Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This is not a recommendation to buy or sell a particular security. The S&P 500® Index is the Standard & Poor’s Composite Index of 500 stocks and is a widely recognized, unmanaged index of common stock prices. Arjuna Capital is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Arjuna Capital including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.