Why there’s yet another chapter to the bull market story
With his famous phrase «Just one more thing...» near the supposed close of his legendary presentations, Steve Jobs would prepare the audience for an important announcement. Would he have used the same words if he were addressing the present bull market? Perhaps. Because a key chapter remains unopened.
Bull markets typically end not in optimism, but in euphoria. And at the moment we see no sign of this critical detail among investors. This is one more reason – even though this now makes us closer to the consensus than we were a year earlier – the Credit Suisse Investment Committee is reinforcing the constructive overall assessment that we formulated one year ago.
Good reasons to favor equities
The strongest global upturn for years
The economy is humming across all continents. Private consumption, reviving corporate investment, cheap energy, rising government spending, high capital buffers at banks and an increase in credit approvals all provide a tailwind. This could become the strongest upturn in decades.
Monetary policy tailwind persists
In the absence of inflation, central banks have neither motive for nor interest in braking the upswing. Their behavior in 2017 offered renewed proof of this. The structural absence of inflation is a characteristic peculiarity of the current cycle. In the past, rallies ultimately provoked their own demise as they overheated, sparked inflation and thus set off the monetary policy brakes.
But not this time. Milton Friedman’s dictum that «inflation is always and everywhere a monetary phenomenon» is relativized by Leo Tolstoy’s «War and Peace» model. Inflation cannot simply be programmed through monetary policy. Peace, globalization, digitalization and demographic aging are the structural deflators of our time. As long as inflation remains on the sidelines, there is nothing to fear from monetary policy.
The doves continue to dominate the hawks
The recurring fear that monetary policy hawks could «let the air out» of the equity rally overlooks a key detail. Monetary policy constraints today are incomparably greater than they were before the 2008 financial crisis. This is largely because central banks now hold huge amounts of their own government’s bonds. So, today more than ever, the office influences the official – not the other way around. And this is why even hawks change into doves as soon as they personally assume the burden of responsibility for monetary policy.
In Switzerland, Thomas Jordan is programmatically following the monetary policy of his predecessor Philipp Hildebrand, and in the eurozone, Jens Weidmann would similarly be likely to adopt Mario Draghi’s monetary policy, if he were to succeed Draghi at the helm in 2019. And in the USA, continuity at the Federal Reserve is ensured with the nomination of Jerome Powell.
As long as inflation remains on the sidelines, there is nothing to fear from monetary policy.
A new credit cycle is emerging
After ten years of balance sheet contraction and recapitalization, Western banks now have more reserve capital available to absorb losses than they have had in more than 35 years. This is important, because the capital base and credit appetite of banks ultimately shape the investment dynamic of the economy.
Low interest rates and highly liquid banks create a constellation in which banks and industry have mutually high interest in more debt-financed investment. At the same time, companies can refinance existing debt with new loans at better conditions, which stabilizes their margins while offering banks attractive earnings potential.
The earnings outlook is better than it seems
Since global economic growth is outpacing wage growth, profit margins continue to expand. Typically, the late, investment- driven phase of a bull market is particularly favorable to equities, because it spurs write-offs and productivity and counters wage pressure with automation.
After all, most current profit margins are lower than suggested by the global average. This is because profit margins are disproportionately high in the technology sector, primarily, where monopolistic structures boost margins and pricing power. In other sectors, on the other hand, margins are not even above average and continue to offer growth potential.
Relative equity valuations are still attractive
Consensus estimates for equity risk premiums amount to 6% for the USA and 8.2% for the eurozone. Although our estimates are lower, they are still well above the respective capital market yields. And not by a trifle, but rather three times more than investors can expect from bond investments. In a phase of euphoria, equity and bond risk premiums would converge. This is nowhere near the case at present. Indeed, today some stock markets actually display lower volatility than bond indices.
More under-invested bulls than over-invested bears
The average equity allocation for pension schemes and private investors is still below average at 30%. The chart below clearly illustrates the repeated message that the bull market to date has been driven less by investors than by companies buying back their own shares. As long as their earnings yield exceeds borrowing costs, such transactions boost their return on equity.
Risks in the current bull market
So where are the risks? On the one hand, there are singular risks – the “black swans” of geopolitics, the environment, technology and society. On the other, structural risk factors in five areas are especially significant.
- A politically motivated over-stimulation of the economy through additional tax cuts and fiscal stimulus could well generate wage inflation and a monetary policy response.
- A central bank could attempt to squelch any stock market euphoria – under the assumption that in the long run, stock market bubbles are more costly than a prompt correction.
- The reform agenda in China under Xi Jinping could strangle debt-financed investments, force company closures and undermine China’s growth momentum.
- A spike in oil and commodity prices could trigger an economic reversal.
- An increase in the presently low number of corporate bankruptcies could have a similar effect.
So, there are plenty of reasons to stick with a disciplined and prudent investment process, and not be blinded by psychology.