Death of a bull market

With the bull market run now the second-best since World War II and the third longest in history, the obvious question is when will the good times end?

05 Mar 2018

It's official! The US S&P 500 and the Dow Jones Industrial Average have officially entered correction territory having each fallen by over 10% in the first few weeks of February. This is not necessarily the death of the bull market, however. Since 1980 there have been no fewer than 36 market corrections of 10% or more. In the 12 months that followed the average return was 16%. In the 24 months that followed the average return was 28%. Yet with the bull run now the third longest in history, the obvious question is when will it end? Bull markets don’t die of old-age. Here are three of the most likely causes of death.

1. Recession

While it is true that not every bear market leads to a recession, every recession has been preceded by a bear market. So what are the chances of a recession? In the near-term, the probability is low. As we saw with the payrolls data out of the US last month, jobs growth is continuing at a very strong pace. The January labour market report revealed a record 88 consecutive months of job gains. Non-farm payrolls beat expectations (200k vs. 180k expected) while the unemployment rate remains at a 17 year low and within ear-shot of the lowest since the late 1960s. Other economic data, including manufacturing survey and capex spending also suggest a broadening of the economic recovery. Add to this the prospects of tax cuts and the chance of an economic recession in the near-term are slim.

One of the better predictors of recession is the US yield curve. With the exception of just one false signal (in 1967 when growth slowed but was not considered a recession), the yield curve, as measured by the spread between the 2 year and 10 year Treasury yields, has inverted ahead of every post-war recession. Any flattening in the yield curve is therefore worth watched very closely.

Timing is everything, however. The yield curve can flatten for a very long time before it inverts, if it inverts at all. In the 1990s, for example, the 2s10s curve was flatter than it is now for more than five consecutive years - meanwhile growth was rampant and equities rallied. When the curve has inverted, a recession has typically followed anywhere from 9 months to 2 years later.

2. Interest rates

The US Federal Reserve has raised interest rates five times so far this cycle. The expectation from the Fed itself is that rates will be lifted a further three times this year taking the official rate to 2.25%. This, in combination with a gradual sell-down in the Fed's bloated balance sheet and an increase in supply thanks to a rise in the budget deficit, may be enough to put further upward pressure on bond yields and send equity market valuations lower.

If every recession is preceded by a bear market what are the chances of a tightening cycle leading to a recession? Historically, tightening cycles do lead to recessions. Since 1950, the Fed has embarked on thirteen tightening cycles. Ten of these have resulted in recessions. The three that ended in a “soft landing” were early in the business cycle. The Fed has never accomplished a “soft landing” in a late cycle scenario.

Again, timing is crucial. In 1983 and again in 1994 there was a gap of seven years between when the Fed started raising interest rates and the onset of the next recession.

3. War

Markets tend to panic at the outbreak of war due to the rise in the level of uncertainty and volatility that this causes. The number of potential geopolitical events is rising by the day under the Trump administration – North Korea, Syria, Russia, and China. History suggests, however, that market shocks from geo-political events typically don’t last.

Of these, the most likely cause of death of this bull market is interest rates. The good news is a bear market is not necessarily the end of the world for economic growth. Only seven of the 13 bear markets since World War II have led to recessions. We still remain constructive on equities in the near term. A global synchronised economic recovery combined with expansionary fiscal and monetary policies and a subsidence in political risk bode well for corporate earnings and hence global equities in 2018.

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