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A bull market seems like that elusive dream where investors fantasize about the prospect of rising disposable income. Where optimism soars higher than Boeing’s Starliner spaceship…when it works! You can feel the unbridled optimism on the trading floors, brokers high-five each other like they’re watching Toronto in the Stanley Cup Finals. Which is a propos since bull markets are about as rare as Toronto in the Stanley Cup finals.
In a bull market, even the most mundane things become exhilarating. A 50 basis point rate cut orchestrated by a more dovish U.S. Federal Reserve sparked what is affectionately referred to as a “relief rally.” And don’t ask…relief from what?
Option volume has spiked as day traders ride the bucking bull in search of lottery style gains. And when your option pays off, you don’t just fist pump; you break into a spontaneous moonwalk, because, hey, for the meme-stock generation, the moon is the limit!
In the current environment, typical of bull markets, fundamentals be damned because the technicians whose main claim to fame before computers was that they knew where to buy graph paper cheap. Now they sit in front of computer screens ready to tap the “buy-on-the-dip” button.
Logic takes a back seat to greed. Retail investors with questionable math skills rally around stock splits. To their minds, getting more shares is akin to Cinderella’s pumpkin carriage turning into a Tesla Cybertruck. But enough of the hyperbole. Let’s consider the facts.
Since the lows of last November, North American financial markets have come alive like a phoenix rising from the ashes. The welcomed 50 bp rate cut by the Fed was really a cherry on top of the sundae. The real story is the marked change in the tone of Fed Speak.
Inflation may not be beaten, but it is moving in the right direction. And from a sentiment perspective, a dovish central bank implies that financial markets have an embedded put that will come to the rescue should a black swan event emerge. Say hello to the “risk-on” trade.
The back story is a spellbinding chronicle. The U.S. Federal Reserve spent the last 18 months in a quest to engineer a soft landing, and by all accounts they may succeed. Sure, the labour market is waning, but U.S. joblessness remains in the range of full employment. The outsized September rate cut, according to Chairman Powell, was to ensure that the economy remained on solid footing. It was not set in motion to deal with an unexpected dot-plot.
Deloitte Economic Research notes that we may be entering a golden era for labour markets. Much of the excitement surrounding the labour market hinges on increased productivity bolstered by investments in software and technology, notably Generative Artificial Intelligence (AI).
If AI is as transformative as many believe that it will be, it has the potential to transform certain types of work. According to Deloitte, an optimistic view of the uptake and usefulness of new technologies could enhance productivity by an average of 1.8% per year from 2024 through 2028, well above the 1.5% baseline.
If you add above-trend population growth to the productivity dividend, that could have an exponential impact on economic growth. Especially if that increased population finds its way into the labour participation rate and the entrenched trend of workers delaying retirement continues. That combination leads to a domino effect as a larger more productive labour force leads to more output and consumption, that acts as a virtuous cycle that lifts the overall economy.
The long-term prospects for U.S. suggest that GDP will rise above-trend through 2028 and perhaps beyond. Deloitte estimates that from 2024 through 2028, GDP will increase at an average annual rate of 2.5% per year, 0.5 percentage points higher than the baseline. “This scenario also results in higher long-term potential for the economy at 2.8%, compared to 2.2% in the baseline. In that sense, this scenario shows what it would take to make recent rates of economic growth sustainable in the long run.”
The bullish tone emanating from North American stock markets is premised on the soft-landing scenario. Although there is no official definition of a soft landing, it is considered for the purposes of this analysis to occur when real GDP growth expands, on average, for three quarters at a pace below the U.S. economy’s potential growth rate (currently 2.0% per the Congressional Budget Office’s estimate) with none of those quarters showing an outright contraction. If the U.S. economy grows at a 1.5% annualized rate in the third quarter of 2024 – the current consensus estimate – it will have met this definition of a soft landing.
This marks an important milestone because, when it has occurred historically, the economy has tended to accelerate in subsequent periods. This pattern could repeat in 2025, especially if the Fed continues to lower rates.
Capital Economics produced a line chart that illustrates U.S. real GDP growth during quarterly time periods before and after a soft landing during a pre-2006 period, post-2006 period and the current growth cycle. Overall, the chart shows that economic growth tends to accelerate for several quarters after a soft landing has occurred.
While nothing is guaranteed, history does offer some guidance about the potential trajectory of the economy and financial markets on the heels of a soft-landing, the tightening cycle that ended in 1995 being a case in point. After an aggressive rate hiking campaign, the Fed ultimately reached a terminal rate of 6.0% in 1995.
Despite that swift pace of pre-1995 rate hikes, the U.S. economy bolstered by the exciting possibilities of the Internet, continued along a path of robust expansion through the year 2000. Along the way it weathered multiple black swan events, including foreign exchange upheavals (i.e., the Mexican peso crisis and the Thai baht devaluation), the Russian debt default in August 1998, which ultimately led to defaults in neighboring countries (including Ukraine’s debt default in September 1998) and the collapse of hedge fund Long-Term Capital Management.
Dealing with these black swan disruptions, the Fed made some nimble policy adjustments that looked a lot like an economic high wire act. With each subsequent move to lower and then raise rates, financial markets gyrated like a roller coaster not knowing whether the Fed would maintain balance or tumble into economic chaos. In the end, the economy survived despite an end of cycle rate of 6.75%.
According to Capital Economics, despite all the turmoil in the 1995 through 2000 era, “core inflation remained at or below the Fed’s 2.0% target. If the current cycle were to repeat the 1995 through 2000 turmoil, we would see a cycle-low Fed funds rate of 4.125% and an end-of-cycle rate of 5.875%.”
Unfortunately, the U.S. economy had more slack in 1995 that it does now. The U.S. unemployment rate was 5.5% in 1995, eventually falling to 3.8% by the turn of the century. Today, U.S. unemployment stands at 4.3%, so there could be less room for error. It is also possible that the same level of interest rates today exerts a greater drag on the economy than it did then because of higher debt levels and demographic changes.
On the positive side, government stimulus, initiatives to promote American made state-of-the-art technology, and massive expenditures on artificial intelligence by hyper-scalers could mitigate the drag from higher interest rates. On that note, so far so good!
The U.S. economy does appear to be tolerating higher interest rates and, despite recent concerns new job openings continue to rise but at a much slower pace. The recent uptick in the U.S. unemployment rate occurred despite the addition of 114,000 new jobs.
That is indicative of an economy where rising unemployment has more to do with an upward revision in the labor participation rate rather than a slowing of the job market. More to the point, this is precisely what Fed officials would like to see, because it should moderate wage demands, which short-circuits any notion of a wage-price spiral.
Caveat emptor! If the economy reaccelerates and profits expand in 2025, it will probably increase demand for labour which could reignite wage demands.
Based on our analysis of the interest rate futures market, investors expect the Fed to cut rates by an additional 50 bps by the end of this year and more than 100 bps in 2025. That is our base case, but given geo-political tensions, and uncertainties about the implementation of the Trump administrations agenda, we are mindful that a black swan event could occur before the end of 2025.
Which is to say, the bull is alive but any trajectory to higher levels will be choppy.
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
Disclaimers
Content © 2024 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
Image: iStock.com/gorodenkoff
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