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The bull market is more than five years old and the Federal Reserve continues to taper its bond-buying stimulus, with potential rate hikes coming next year. Should investors be scared?

Not according to Michael Hood, global market strategist at J.P. Morgan Asset Management. He makes the case that we are, at most, midway through the business cycle – making stocks a better bet than bonds, and cyclicals better than defensives. As for his bearish views on the Canadian dollar, read on.

Q. The consensus among economists is that the Federal Reserve won't start raising its key rate until mid-year 2015. Are you in that camp?
I'm in that camp. I think they have room to be patient here but it is clear that they are making some progress toward their dual mandate [of maximum employment and stable inflation].

The Fed believes that the drop in the unemployment rate overstates the degree of improvement in the U.S. labour market because labour supply has been very weak, but hiring has been reasonably acceptable – so it is clear that some healing is happening in the labour market.

Inflation, which has been running too low from the Fed's perspective appears to have troughed and may be starting to climb gradually toward the target. At the same time, the Fed does believe that there are structural headwinds facing the economy, and that there is plenty of spare capacity, particularly in the labour market, so there is no need to rush here.

The risk over the next three-to-six months is that the Fed strikes people as being more hawkish than the market is pricing in. If you look at current market pricing, it's already a little more dovish than what the Fed itself has been saying. For example, the 2015 forecast from the Fed in March had the cash rate at 1 per cent; the market is priced to about 0.75 per cent.

Q. A lot of investors feel that the bull market will come to a violent end, as it did in 2008. Does it have to play out that way?
No. The last two business cycles played out in such a way that you had an environment of low interest rates and low volatility for such an extended period that people wound up taking a lot of risk; a lot of leverage was put into the system. Ultimately you had implosions in the financial sector that sent the economy into recession.

If you look at the way things are going now, the reaction to the last crisis is such that you've had a massive change in the regulatory environment that's designed to impede taking too much risk or adding a lot of leverage.

I think we are most likely in the early- to middle stages of the current expansion. And while it is reasonably likely that a financial event ends the cycle, it doesn't seem like we are anywhere close to that point yet. It doesn't feel like an aging business cycle.

Q. But with the Fed holding rates near zero per cent, aren't investors taking too much risk?
Not yet, and certainly not across the board. I would argue that one of the reasons why growth has been so weak and why rates have been held so low for so long is precisely because we have not yet gotten a genuine credit cycle going in the U.S.

If you compare gross domestic product with the pre-recession peak, we're by far the lowest we've been in the post-war era five years into a cycle, in relative terms. If you look at bank credit, it's barely in positive territory in growth rate terms. And equity pricing is where you'd expect it to be in the middle-point of a business cycle.

Q. Do you see a spike in market volatility when the Fed ends quantitative easing later this year?
It seems reasonable to expect some increase in volatility, probably more as we get closer to the date of the first rate hike. In particular, you should expect to see increased sensitivity of things like short-term interest rates to economic data surprises.

But to the extent that we are in the middle of the business cycle, market volatility typically is low. Also, to some degree, volatility should be related to macro-economic volatility – and macro-economic volatility is extraordinarily low by long-term standards. Things like fluctuations in GDP growth rates has been quite steady.

Q. Investors have a lot to consider these days, from the end of QE and zero per cent interest rates to rising bond yields. How should they position themselves?
My market view is based on this premise that we're in the middle rather than advanced stages of the business cycle, as well as the idea that we're coming to the end of exceptionally low interest rates. That strongly argues for people to be overweight equities and clearly underweight fixed income.

Relative valuations are strongly in favour of equities. If you look at simple equity risk premium calculations, they are still quite high by long-term standards. Equities have a fairly consistent pattern of continuing to rise through the course of the business cycle, until you get to the point where you can sniff the next recession coming. I wouldn't regard equity valuations in absolute terms as a significant obstacle at this stage.

In fixed income, you should be looking at bonds that pay you a higher coupon than Treasuries or Government of Canada bonds – and that brings you to high yield corporate bonds. They look expensive by long-term standards, because yields are low at about 5 per cent. But that's only because Treasuries are yielding 2.6 per cent, so the expensive part of the fixed-income market is not the credit-risk part; it's the risk-free part of government bonds.

Q. What about within the equity market. Where should people be investing?
Over the remainder of this year, we're likely to see an outperformance by cyclical sectors, which we saw in the second half of last year. For the first several years of this bull market, defensive sectors were persistently outperforming because people had a great deal of enthusiasm for stocks that looked by bonds. But my assumption is that economic growth is fine for the rest of the year, bond yields resume their upward grind, and the parts of the market that are exposed to growth rather than bond yields should do quite well.

Q. How big of a threat is China to the market?
I don't think China looks like a classic emerging market blow-up story, where an economy is living on foreign credit. China is a net external creditor, so it's growth hasn't been financed by foreigners.

It looks more like the U.S. in the 2000s, where you have a big buildup of internal leverage. An implosion there could send the economy into a period of weak growth. The damage that would do to the rest of the global economy would be more limited than a classic emerging market blow-up because you don't have the same sort of financial linkage. Companies that are exporting to China would suffer; commodity producers would suffer – but the pain wouldn't cause specific large stress-points.

Q. How does Canada fit in with your world view?
There seems to be less economic slack in Canada than in the U.S., and Canada is less likely to get support from its housing sector over the next number of years. If you look at relative growth prospects, I'm more upbeat about the U.S.: I feel like Canada is operating closer to its current potential level of output than the U.S. is. So I feel the U.S. is positioned to outperform its trend growth rate.

While the exchange rate has already corrected a significant amount, there may be more to go. Over the course of the next several years, we're more likely to see additional depreciation of the Canadian dollar. With the commodities supercycle essentially ended and terms of trade normalizing, it is reasonable to expect exchange rates will move back closer to where they were in 2002.