The main point of difference between the bulls and bears is their outlook on the US economy. The more cautious feel that as we are in the 10th year of an economic expansion, a slowdown is imminent. The slowdown will morph into a recession as we have rising rates and tightening monetary policy by the Federal Reserve. This recession will hit before the consensus view of late 2020, and in a recession, markets fall at least 20 per cent. Markets will begin to decline at least six months before the recession itself actually hits.
The bear thesis rests on rising rates, driven by rising inflation, caused by full employment. They make the point that the US has already hit full employment. There are more job vacancies than unemployed people in the US today. The number of people outside the labour force looking for employment is near all-time lows, and every business survey highlights the difficulty in hiring qualified employees. Numerous studies have shown the asymmetric nature of the relationship between unemployment and wage pressures. Wages surge once we cross full employment. That is where we are in the US today. Wages are poised to accelerate. Already in Q2 2018, the employment cost index rose by 2.8 per cent, its highest point in a decade.
Already even before wages have begun to accelerate, the core personal consumption expenditure deflator (Federal Reserve’s preferred inflation measure) is already at 2 per cent for the last few quarters, exactly at the Fed’s target. As wages accelerate, inflationary pressures will build, forcing the Federal Reserve to be aggressive in hiking rates. Markets and the current consensus of only 125 basis points of hikes in rates through the end of 2019 may be caught napping.
We may also have an environment in the US where rates are higher and growth slower (due to these same-capacity and labour constraints) than current expectations, a horrible set-up for equities.
The bulls are obviously far more sanguine. They do not feel that inflation spirals out of control and question the relationship between unemployment and wage pressures. Bears have been calling for surging wages for years now. Inflation has continued to be benign. They also feel the Federal Reserve will take a more symmetrical view of inflation, and let the economy run a little hotter for longer. They do not see recession risk in the US in 2019 or even 2020 for that matter. They feel it is too risky to leave one last burst of market performance on the table. It can be career finishing.
Another point of difference between the bull and bear camps is on the trade wars and tariffs. The bulls feel it is just posturing and noise. Better sense will prevail and some type of face-saving deals will be eventually struck.
Illustration by Ajaya Mohanty
The bears point to the damage already visible and the entrenched position both China and the US have already dug themselves into. It is already starting to impact global supply chains and corporate investment. No MNC likes uncertainty of this type. There will be unintended consequences across countries and sectors. There exists a genuine but unpredictable risk that things spiral out of control, which would be corrosive to all risk assets.
The third point of differentiation is on the outlook for corporate earnings, especially in the US. The bulls point to the fact that earnings have grown by 20 per cent in the last two years (up to Q2 2018) in the US. The current earnings season is also on track for 25 per cent growth and companies are beating expectations on both revenues and profits. Long-term earnings growth expectations are over 15 per cent, the highest since 2000. Earnings have consistently over delivered in this bull cycle. Combined with record share buybacks, these two props to the bull market show no signs of reversal.
The bears point to the fact that labour’s share of income in the US bottomed in 2014. This also marked the peak in margins as based on the National Income accounts for pre-tax profits. Since then the National income (NIPA) series has actually shown a fall in margins. A significant gap has opened up in corporate profitability as reported in the National Income accounts in the US and by the companies themselves (S&P series). The National Income accounts are generally more stable and less affected by accounting changes and differences in tax rates. This series was definitely more reliable as an indicator of corporate profitability in the 2000 tech boom and the current gap between S&P earnings and NIPA numbers has rarely been larger. Years from now will we look back and with the benefit of hindsight wonder whether the boom in corporate profits was as robust as it appears today? That is what happened in the tech bubble when there was a sharp pullback in corporate earnings in the ensuing bust post 2000, and the two earnings series converged again.
There are other friction points beyond the three mentioned above. We have the ever-present concerns on China and its attempt to deleverage and have a simultaneous soft landing. The dangers of a strong dollar and obvious geopolitical concerns around Iran and North Korea.
Be that as it may, I have rarely seen the smart and experienced money getting so cautious and building cash. They may be early and are less concerned with maximising any remaining upmove left in global equities. As one friend told me just the other day, “We are entering a period of capital preservation and lower returns. Be cautious, be safe. This will end badly. It always does.”
The writer is with Amansa Capital