Trevor Greetham: Goldilocks will beat the bears for some time to come

Do not be spooked by recent falls. The bull market has further to run.

Stockmarkets have been thriving in the not-too-hot, not-too-cold “Goldilocks” backdrop of the last few years. Growth has been strong enough to boost profits, and inflation low enough to keep central bank policy loose.

Recent stockmarket weakness is centred on signs that wage inflation may finally be gathering steam in the US, and interest rate rises may also speed up, but a cooling off in China could allay inflationary concerns once more as the year progresses.

Equities have been getting expensive, with Robert Shiller’s cyclically adjusted price/earnings multiple for US stocks back in late-1990s territory. The Bitcoin phenomenon is very reminiscent of the dotcom mania of the 1990s bull market, and is symptomatic of the high degree of global liquidity.

However, with interest rates still low, and growth solid, the Goldilocks bull market has further to run.

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Turning back the pages, we can see a lot of parallels between the market backdrop today and the very long 1990s stockmarket expansion. Commodity prices were falling from the 1990 Gulf War onwards as the Japanese economy began to shrink, and supply from the former Soviet Union increased. Growth was good, but monetary policy remained loose under then Chairman of the US Federal Reserve, Alan Greenspan.

It all ended with the irrational exuberance and silly stockmarket valuations of the dotcom bubble.

The length of the current bull market is directly related to the length of the business cycle. The world is again experiencing one of its longest ever expansions. We put this down to three factors keeping the magic spell of low inflation and low interest rates in place.

First, job losses and business failures in the crisis of 2008/2009 created a significant amount of spare capacity in economies. Second, governments in the UK and Europe cut spending in an attempt to rein in public debt, dampening economic recovery. Third, “cost push inflation” remains low as China rebalances away from commodity-intensive industries.

All good things come to an end, however, and we are watching the Investment Clock model that guides our asset allocation carefully as it moves into the Overheat phase, characterised by strong growth coupled with rising inflation.

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Global growth remains on a strong positive trajectory, with lead indicators pointing upwards and a strong trend in place. Unemployment rates are falling in all of the major economies, and business confidence is high. Meanwhile, inflation lead indicators have also perked up lately on the back of rises in the oil price.

Our inflation lead indicators have been pointing downwards for most of the last decade, as they did during the deflationary 1990s. This is not the first time we have moved into Overheat over this time. But each time so far something has happened to release the steam, allowing inflation to drop and moving the clock back into the equity-friendly Recovery phase.

The risk this year is that inflation keeps rising and interest rates follow, which is what has been spooking investors these last couple of weeks.

You would not think a US economy in its ninth year of expansion would need fiscal stimulus, but the Trump administration has announced the largest ever corporation tax cut.

This could supercharge the US economy and trigger an unwelcome rise in core inflation and wages.

Investors have been worried that a stepping up of rate hikes from the US Federal Reserve will mean a sustained sell-off in US treasuries, which could impact highly valued equity markets.

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But sell-offs should provide an opportunity to add to equity overweights. Stockmarkets tend to keep rising during a period of monetary tightening, rolling over only once growth actually peaks out. With the Fed Funds rate still below the rate of inflation, and the second and third largest central banks in the world still printing money, it is much too early to worry about recession risks in the US or elsewhere.

It is also possible that we see things cool down again. The downside growth risk the market is not talking about is from China, where tighter monetary policy is likely to cause a slowdown this year, and where house prices have already stalled.

Stockmarkets did not like Chinese weakness in 2015 and 2016, but on the plus side, a drop in commodity prices would take the steam out of inflation and elongate the business cycle still further. We would therefore look to buy into such a dip in stocks. If Chinese weakness causes the Fed to pause or even reverse its rate hikes, this business cycle could outlive even the 10-year expansion of the 1990s.

It is not surprising investors are bullish and valuations have been getting expensive. Stocks could dip for a while if the Fed hikes rates more aggressively than expected, or if the slowdown in China gathers momentum. Nevertheless, for now at least, the porridge is just right, and there is still time to enjoy it before the bears come knocking at the door.

Trevor Greetham is head of multi asset at Royal London Asset Management

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