The “Goldilocks” rally still has juice.
That perfect environment to sustain broad market gains – when global growth is fast enough to lift corporate profits, but tame enough to keep inflation muted – should be in effect for at least another 12 months, according to Kevin Gaynor, the head of international economics at Nomura Holdings Inc.
As the business cycle reaches its climax, European stocks, high-yield bonds and emerging-market credit have the potential to catch up with valuations notched in the halcyon days before the 2008 financial crisis, he said.
“We could get a more extended market rally,” Gaynor said in an interview. “When labor markets are tight and economic growth operates above trend, you see corporate profitability dropping, and that’s one reason to get bearish. For now, we aren’t seeing that type of margin pressure.”
The U.S. equity market is in the throes of its second-longest bull run in history, global high-grade credit spreads are sitting near post-crisis lows, and volatility in stocks, bonds and currencies is at record lows. The latest cycle of economic growth in the U.S. kicked off in June 2009, making the current period of expansion the third-longest since the 19th century.
Figuring out when the business cycle is going to end is key for investors. The thinking goes that in the late stages of an expansion, corporate profits will decrease as wages climb, while rising interest costs crimp returns on capital.
There are few such warning signs at the moment, according to Gaynor. Some 78 percent of S&P 500 companies, for example, have beaten earnings expectations in the second quarter.
Still, policymakers must ensure things don’t overheat. Figuring out the level of economic slack is a challenge in the best of times, not least in the post-crisis era.
Nomura estimates that the output gap — the difference between projections for sustainable growth and realized expansion — for advanced economies is in positive territory. That suggests economies are a little overheated. But the model — drawing on manufacturing and labor data, including excess inventories, capital expenditure and structural employment — is some 20 percent below previous peaks, taking the period since 1990 as a starting point.
So there could be more juice left in the current cycle, and more risks can build up in the financial system as economies expand above potential, all before a sustained drop in corporate profits triggers a reversal in the business cycle.
Nomura’s second yardstick for a cycle in the late winter of its expansion – over-exuberant markets relative to economic conditions – also isn’t ringing alarm bells yet. Its indicator of cross-asset risk appetite is 10 percent off the peak witnessed at the height of the global credit bubble in February 2007.
The big risk to watch: An increase in real interest rates. Former Federal Reserve Chair Alan Greenspan, for example, sounded the alarm over bond valuations in an interview with Bloomberg News on Monday. “We are experiencing a bubble, not in stock prices but in bond prices,” he said. “This is not discounted in the marketplace.”
Higher rates will lower asset valuations unless there’s a commensurate rise in market expectations for growth that would justify a further dip in risk premiums, according to Gaynor.
There may be solace for bulls: productivity growth and regulatory changes that free up bank lending, for example, could prolong the expansion, Gaynor says – but that all hinges on the outlook for monetary policy.
“The Achilles’ heel for risk assets isn’t growth, it’s rate expectations,” he said.
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