Jamie Dimon, chief executive of JPMorgan Chase, raised eyebrows recently when he warned that markets are underestimating the risk of drastic interest-rate increases.
Other prominent voices are also urging investors to be wary of this aging bull market. This week, Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, reduced her outlook for the S&P 500 and said “the bull is limping.” In a similar vein, John Higgins of Capital Economics said he sees the benchmark ending next year roughly 15 per cent below where it is now.
So be warned: This is not the time to be taking big risks with your portfolio. The trick, though, is judging exactly how much caution is merited. As a new earnings season begins, let’s evaluate the evidence – including three reasons to be at least modestly upbeat.
Strong jobs and profits
Jobs provide the clearest rationale for being cheerful about the state of the North American economy. Unemployment rates in both Canada and the United States are hovering at their lowest levels in years.
Meanwhile, corporate profits in the United States are expanding at their fastest year-over-year clip since 2011, according to Thomson Reuters I/B/E/S. The forecaster expects this earnings season to be spectacular. It predicts that S&P 500 companies will report profits 18.6 per cent higher than a year ago. It expects sales to have expanded at a 7.4-per-cent clip.
Earnings are growing in Canada, too. As a result, the price-to-earnings ratio on the S&P/TSX Composite Index has fallen to around 17, down from 21 a year ago. The benchmark index is now trading close to its most attractive valuation since late 2013, according to Bloomberg data.
No imminent recession
Stock markets are volatile, to be sure, but only rarely do they suffer severe damage outside of a recession. Right now, it’s difficult to detect any warning signs of such a downturn ahead.
Look, for instance, at the yield curve, the most time-honoured recession indicator. It compares long-term interest rates with short-term rates.
Most of the time, the curve slopes upward – in other words, it costs more to borrow money for longer periods than it does for shorter ones. But over the past 40 years, the slope has inverted whenever a recession is on the horizon. As the outlook darkens and investors rush for safety, short-term rates push higher than long-term rates. This usually occurs several months before the real downturn hits.
At the moment, the yield curve is still sloping upward in both Canada and the United States. To be sure, it has flattened rather dramatically in the past few months – that is, the gap between 10-year rates and two-year rates has narrowed. But it still costs more to borrow money for longer periods than for shorter periods.
Judging by the yield curve, there are excellent reasons for investors to be cautious, but no reason to expect a recession this year.
Still low rates
The U.S. Federal Reserve appears to be intent on raising rates. It did so in March and it is expected to follow up with a couple more hikes by year end.
That has fuelled concern that rising bond yields may draw money away from stocks. If wages and inflation were to surge, and the Fed had to take drastic action to rein in the economy by suddenly jacking rates higher, stocks could take it on the chin. That’s the nightmare scenario envisioned by Mr. Dimon.
Fair enough. But despite all the fretting, the measures of core inflation favoured by the Bank of Canada and the Fed aren’t exactly flashing red.
In both countries, prices are rising at around a 2-per-cent-a-year pace, right at the central banks’ targets. After several years in which inflation persistently fell short of targets, it’s difficult to see why policy makers would want to suddenly slam on the brakes with unexpected interest-rate hikes.
If yield curves aren’t inverted, interest rates are unlikely to surge and corporate profits are expanding at a healthy clip, why should investors fret? One reason is geopolitics. Whether the issue is potential tariff wars, North Korea’s nuclear program or NAFTA negotiations, there are ample opportunities for sudden, nasty surprises.
Another concern is valuation. When measured against their long-run historical earnings, U.S. stocks look very expensive, despite their recent profit gains. On the same measure, Canadian stocks appear cheaper, but no bargain.
Finally, there are questions about what happens when the recent wave of U.S. tax cuts and fiscal stimulus begins to dissipate. At Capital Economics, Mr. Higgins worries that “the U.S. economy, which is already running into capacity constraints, will slow next year as fiscal stimulus fades and tighter monetary policy bites.” He sees growth in gross domestic product sliding from 2.8 per cent this year to only 1.5 per cent in 2020.
It’s impossible to know exactly how all these factors will play out. “We are in the later innings of the market cycle, but growth indicators in the form of GDP results and corporate profits could prove supportive enough for the equity cycle to continue for some time,” according to Mawer Investment Management.
Investors should be wary. But, based upon current evidence, it appears as if there’s time to sidle, not run, away from this aging bull.