Investors have good reason to be cautious, judging from a Citigroup report this week that debates whether we’re at the end of this stock market cycle, with a bear market imminent, or merely late in the cycle, with a chance of some decent further gains before the inevitable crash.
Matt King and Robert Buckland of Citi acknowledge the usual indicators are a mixed bunch. On the one hand, a flattening yield curve and lofty levels of corporate debt suggest this nearly decade-old bull market is ready to topple over. On the other hand, strong profit growth and still-low interest rates signal the bull could still have further to run.
As the Citi report makes clear, much will depend on how central banks proceed from here. After the financial crisis, monetary policy-makers nursed stock markets back to health with rock-bottom rates and unconventional asset purchases. “But now that has changed,” the Citi analysts say. “As central banks step back, so the credit and equity markets will catch up with fundamentals.”
They’re not the only ones to be concerned about what will happen when the global trend toward higher interest rates collides with growing levels of corporate debt. Around the world, corporate bond issuance has more than doubled over the past decade, according to a report in June from McKinsey Global Institute. While companies in emerging markets have been some of the biggest borrowers, Canadian and U.S. companies have also loaded up on debt, according to the McKinsey report.
In a similar vein, a report last year from the Canadian Centre for Policy Alternatives sounded alarm bells about the run-up of borrowed money in Canada’s corporate sector. Canadian non-financial corporations took on $671-billion in new debt between 2011 and 2016, according to the CCPA.
Of course, central bankers know all about this mountain of new business debt. Conventional wisdom says they will move with enormous caution to bump rates higher and avoid disruption. But it’s worth pondering the possibility that hikes could be faster than we expect.
This could happen if inflationary pressures continue to swell. In the United States, the underlying inflation gauge maintained by the Federal Reserve Bank of New York hit 3.33 per cent in June, the highest level since before the financial crisis.
In Canada, the broadest measure of consumer price index (CPI) inflation touched 3 per cent in July, its loftiest level since 2011. While the Bank of Canada prefers to use various adjusted measures of CPI, even those metrics show inflation running around 2 per cent.
Most economists see this mild inflationary surge as nothing to worry about. After years in which inflation persistently fell short of the 2-per-cent level that central bankers generally desire, a couple of years in which price increases meet or surpass that target is no reason to get excited.
But it’s equally true that it’s difficult to predict where inflation will go from here.
Back in the 1960s and 70s, low unemployment went hand in hand with rising prices, prompting central banks to drive rates higher to stamp out inflation. It's possible that today's squeaky-tight job markets in Canada and the United States could have a similar effect now.
However, the evidence of the past 25 years indicates the link between lower unemployment and higher inflation may not be as strong as it once appeared. For the moment, it's all conjecture: Economists don't understand enough about the mechanics of inflation to know for sure whether it will roar back to life in today's booming economy.
For investors, this means a high level of uncertainty. What is clear is that interest rates are ticking at least somewhat higher, that corporate debt has swelled and that fixed-income securities are providing much more competition for stocks than they did a couple of years ago.
Those trends shouldn’t scare you out of the market, but they are good motivation to hold higher-quality, more-stable firms with ample ability to meet their debt obligations. Whether you think this is the end of the market cycle, or merely getting close, it’s a good time to take some risk off the table.
Ian McGugan