These days, we’re experiencing a late-cycle bull market. That’s not really anything new or uncommon—we’ve seen such markets before. And it might look like any other in recent history.
For instance, unemployment is low. In fact, the US Federal Reserve labels today’s economy as full employment and has therefore increased interest rates to counter the inflation that piggybacks wage growth. And, capital markets are seeing high equity valuations and narrow credit spreads. These conditions are typical in the later stages of economic, market, and credit cycles.
However, two factors differentiate this bull market: Tariffs and the fiscal stimuli of tax cuts and increased spending. In this article, we’ll discuss how these factors could impact the market cycle progression, economic growth, and the risk of a recession.
The White House’s stimulus initiatives consist of the 2017 tax cuts and the increased spending bill from February this year—a stimulus package roughly the same size as the one Obama introduced in 2009 to recover from the financial crisis. So, while the size isn’t unusual, the timing definitely is, especially considering that the Federal Reserve is tightening the monetary policy.
Thus, the question before us is this: Will the Trump stimulus package extend the economic cycle, or will the increased economic activity boost asset valuations and push us closer to the next recession?
In our point of view, the next recession is going to happen between 12 and 24 months from now. We are convinced that any increase in economic activity will lead to inflationary pressure. The Federal Reserve’s target goal is 2% inflation, and it will react to inflationary pressure by further tightening its monetary policy (e.g., increasing interest rates).
A more aggressive monetary policy is likely to worry the financial markets, especially the bond market, because most recessions are caused by faulty monetary policy. Here, increasing the interest rates will probably be viewed as a mistake.
As a result, the US Treasury yield curve will likely flatten, then invert, meaning that the 2-year yield exceeds the 10-year yield. Typically, equity markets then drop, leading to a recession in 12 to 15 months. We wrote extensively about this important indicator here.
Tariffs and trade wars
The stock market is very sensitive to talks about tariffs and trade wars. Why? Stock markets hate uncertainty. Over the past century—and, in particular, the past 40 years—the world has been heading towards free trade, and when the world’s largest economy starts talking about tariffs and trade wars, it implies change, thus uncertainty.
The current tariffs may not qualify as a trade war, but if the US enacts more aggressive protectionism against China, we could be heading towards a full-blown trade war. Our dynamic CVS (Cycle, Value, and Sentiment) process would most likely make us downgrade our cycle scores to the point where we would be likely to experience a recession and a bear market.
We don’t expect this to happen, but we will be keeping a close eye on the situation. What we do expect is that the Federal Reserve will increase interest rates to counter inflation. We also expect that the yield curve will invert as early as the end of this year. Last but not least, we expect the stock market to increase in value and bonds to show positive results before the correction hits us. Investors in short term financial assets may rejoice at this projection, but anyone in longer term investments should diversify into precious metals to insure their portfolios against the uncertainties ahead. Contact us to receive a free guide to learn how you can protect and grow your wealth.