January’s burst of equity-market euphoria has given way to fear of a trade war, a more hawkish Fed and the return of volatility. The challenge of late-cycle investing is that equity valuations are stretched, there are worries about the economy overheating and the Fed is taking away the punchbowl. At the same time, economic growth and earnings are strong. The added complications are that the US federal government has enacted substantial fiscal stimulus at a time when the economy is at full employment, and President Trump is imposing trade sanctions that could escalate into a major trade war. However, the tit-for-tat tariffs triggered due to US steel and aluminium import tariffs are trivial in size. All the other tariffs are just proposals, contingent on the US and China being unsuccessful in reaching a negotiated solution. Hence, so far it has been a phoney trade war between the US and China.
Ten years since the global financial crisis, investors can find differing signals in the market. On the one hand, there are signs that economic growth is becoming less dependent on stimulus from central banks. On the other hand, valuations appear to be stretched for most asset classes. History suggests that average economic cycles are about 6 years long, but this year will mark the tenth year since the start of the recovery. We must keep in mind that recovery from a banking crisis normally take longer than other forms of financial crisis. Nevertheless, an economic downturn therefore might be expected in the not too distant future. Central banks are likely to become net sellers of bonds in 2019, as the exceptional post-crisis measures are phased out. Could that mark a turning point in the cycle? Or will some other event be a catalyst?
Some investors believe that because the current bull market and economic expansion have gone on for some time, a bear market and a recession will take place soon. At this stage, there are no signals that usually warn of a coming recession, such as a loss of economic momentum or an inverted yield curve. A market correction could still happen at any time, because of the overly optimistic sentiment. Whilst central banks continue to unwind their quantitative easing policies, politics have generally become more favourable to the economy. Politics has moved from fearing debt and deficits, to using fiscal policy to support growth, as seen in the US where tax cuts have just been legislated.