Does the Bull Still Have Room to Roam?

THE BULL MARKET in equities is now more than nine years old, making it the second-longest bull market in United States history. While the bull market has aged gracefully, some investors are questioning its staying power given the monetary and geopolitical headwinds that have been buffeting the market this year. In the following interview, Christopher M. Hyzy, chief investment officer at U.S. Trust, discusses both the risks that could slay the bull and the positives that could extend its run.

The equity market has been highly volatile despite a strong U.S. economy and record corporate earnings. Why are investors so nervous when the fundamentals appear so supportive?

It’s a function of where we are in the market cycle and the current risks that could usher in a recession and bear market. We’re in the late stages of one of the longest bull markets in U.S. history, so naturally investors are going to be wondering how long the run will last and what might do it in. Every potential threat is magnified because the bull is so long in the tooth. I’m not saying the risks aren’t real. We have rising bond yields, increased commodity costs, wage pressures, the possibility of a change of control in Congress, the threat of a “cold war” with China, and the political uncertainty in Italy. So investors have reason to be nervous, but there are just as many reasons to remain optimistic about the prospects for equities.

Of the risks you mentioned, which are the most threatening in your view?

The most worrisome risk, in our view, is a jump in inflation and more aggressive Federal Reserve [Fed] tightening than the market is expecting. That’s the biggest concern because interest rates obviously affect the pricing of trillions of dollars in the bond markets, which affects equity prices. A spike in yields generates larger flows into bonds at the expense of equities, which drives down stock prices. At this point, we don’t expect inflation to spike. We’ve seen commodity prices rise this year, and there are labor shortages that could translate into higher wages, but there are also offsets to those pressures, such as automation, outsourcing and a stronger dollar. So the uptick in inflation is more tactical than strategic. We might get a bout of short-term inflation, but, in our view, it’s not sticky.

Given that assessment, what path is the Fed likely to take over the next 18 months?

The Fed has said it wants the Fed funds rate to reach 3%. That’s its neutral rate, the rate that neither stimulates economic growth nor chokes it off. Right now the Fed funds rate is 1.75%–2.00%. The yield on the two-year Treasury is telling us it should be above 2.5%, which is where we think it will be in 2019. That is a very modest increase over its current level and nothing that would trigger a recession or bear market, in our view. The wild card is the actual level of inflation over the next 18 months versus the expected level.

How concerned are you about recent trade tensions between the U.S. and China?

Trade is the primary driver of global growth, so naturally we’re concerned about the resurgence of protectionism. So far, there has been more saber rattling than real conflict. The tariffs announced by the Trump administration and China’s response are worrisome, but we do not expect them to have a significant impact on U.S. and China overall trade volumes or the countries’ economies by themselves. If the brinksmanship turns to an all-out trade war, that’s a different story. We’re of the mind that cooler heads will prevail because the cost of a trade war would be prohibitive for both countries. Consumers would see higher prices, and the supply chains of Chinese and American businesses would be upended. So it’s in the best interest of both governments to work things out. It’s a situation that’s analogous to two people chained together at the end of a pier. If one jumps, you can be pretty sure he’ll take the other with him.

Does the recent market volatility in Europe present problems for U.S. equities?

There are two issues in Europe. One is political instability in Spain and Italy. The other is slowing economic growth in the European Union. If growth in Europe continues to weaken, that could negatively impact U.S. equities, especially if we see anemic growth in Europe and tighter financial conditions in the U.S.

You’ve discussed the risks to the bull market, but what are the factors that could keep it going?

The most important is the U.S. economy, which is the healthiest it’s been since the start of the Great Recession about 10 years ago. Economic growth is strong and likely to accelerate as the year progresses and business confidence is high, which increases capital expenditures. That investment stokes not only growth but also productivity, which helps keep a lid on inflation. Consumer spending, which accounts for about 70% of U.S. gross domestic product, is likely to rise because last year’s tax  cuts are putting money in consumers’ pockets. So the table appears set for very solid economic growth over the next year, and that bodes well for corporate earnings, which we think will take stock prices to the next level.

And what level is that?

In the fourth quarter of 2017, we forecasted the S&P 500 to be at 3000 at the end of 2018. Given the interest rate concerns and geopolitical uncertainty, we’re anticipating it reaching that number within the next six to 12 months. That would mean about an 11% increase from its current level. We think that target is realistic because of the supportive economic environment and because valuations have fallen from about 19 times earnings at the start of 2018 to less than 17 times earnings now. It’s that combination of a healthy economy, stronger corporate earnings and cheaper stock prices that bodes well for equity investors, in our view.

What do you tell investors who are anxious about putting money at risk at this point in the market cycle?

We tell them diversification is their friend, as it is with every type of market — bull, bear, early stage, late stage, etc. The key to making diversification work is to be well diversified both across and within asset classes. Using stocks as an example, diversification within equities means having an allocation to high-quality large-cap stocks, especially multinationals because of their diversified revenue streams and the exposure they provide to the strong global economy. Those stocks would be spread across multiple sectors, particularly those that tend to do well when economic growth is accelerating, such as financial services and technology. Looking beyond U.S. borders, stocks in emerging markets have very good upside potential because of their lower stock valuations and because of the emerging markets’ strong consumer demographics.

Does being diversified across asset classes still entail an allocation to fixed income?

Absolutely. The current interest rate environment is not particularly friendly for bond investors who are not willing to hold bonds to maturity, but we believe clients need an allocation to fixed income to diversify risk. As with equities, you want good diversification within the asset class by incorporating Treasuries, municipal bonds and high-quality corporate bonds. You shouldn’t have significant high-yield bond crossover at this stage in the cycle unless you’re a thrill seeker. And with interest rates headed higher, you want to emphasize bonds with shorter maturities, which are less sensitive to rate increases.

How do alternative investments fit into the mix, given current macroeconomic and market conditions?

Hedge funds, private equity and other alternative strategies are less correlated to traditional asset classes like equities and bonds, which makes them valuable portfolio diversifiers. At this stage of the economic expansion and market cycle, real assets, such as commodities, tend to perform well. They’re a good hedge against equity and bond risks. Private equity is another area we think our clients should be looking at. We can assume that the returns on investments in the public markets, like stocks, could be below recent trends in the next few years, so it makes sense to gain exposure to private investments, such as startups or distressed companies, where the return on investment could be higher. Private equity can also be a good diversifier.

So, despite macroeconomic and geopolitical headwinds, the bull still may continue its run?

Yes. Our analysis is that absent a spike in inflation or an all-out trade war with China — neither of which we foresee — stocks should rise into 2019. The risks are real, but we believe healthy economic growth will translate into solid corporate earnings over the next several quarters, which should power the market to new heights. There are more worries now than there were at the beginning of the year, but we think there are opportunities to capture if investors stay the course and increase diversification.