Rick Rieder and Russ Brownback examine the more volatile cyclical dynamics we’re likely to encounter in 2018, even as the secular risk-asset bull market remains in place.
Sir John Templeton famously stated that “bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria.” While this thesis is often cited by investment professionals, it is also frequently used incorrectly to make a diagnosis of the contemporary investment landscape. In contrast, we apply the thesis to secular bull markets, which are multi-decade phenomena that begin with overt societal apathy and deep intrinsic value. They peak with significant societal obsession and asset overvaluation. To us, it is critically important to view every cyclical investment landscape through this secular lens. Secular investment trends are durable and tend to pull financial markets through the ups and downs of numerous smaller cycles that are embedded within them.
As we enter 2018, we are firmly entrenched in a virtuous, wealth-creating secular bull market for risk that began in earnest in late 2012. It was born of the severe pessimism surrounding the existential European debt crisis, the burdensome U.S. regulatory paradigm and the demonstrable hangover from the 2008 financial crisis. But the combination of generationally low valuations, asymmetrically easy global monetary policy and ubiquitous disruptive innovation provided the thematic underpinnings. When this secular bull ultimately peaks is anyone’s guess, but that terminal point is not close in our estimation.
A more difficult environment in 2018
In the meantime, an ongoing cyclical ebb and flow will cause sentiment to gyrate between optimistic and pessimistic extremes. In 2015 we entered a cyclical bear phase that evolved sequentially into the current robust risk-on cycle. Ever since, accelerating economic and earnings growth alongside dormant inflation has forced valuations to chase solid fundamental realities.
However, we think 2018 is going to be a more difficult environment. Risk assets are now more fully valued, and buoyant market sentiment is more widespread. Also, the output gap has recently closed for the first time in 10 years and with no economic slack to spare, the economy is bracing for tax reform that will catalyze enhanced corporate investment. Finally, there is good evidence that wage growth is accelerating, as the economy resides near full employment.
We see respectable growth next year
This backdrop would seem primed for the onset of nefarious inflation, but there are several powerful influences that may somewhat mitigate historical drivers of price increases. First, for the more than half the world’s population that is now online, there is effectively perfect information about economic value for nearly every imaginable good and service. Thus, with little economy-wide pricing power, nascent wage increases come mostly at the expense of profit margins. And, while new fiscal incentives will drive more capital expenditure, the traditional multiplier effect will be dampened as a portion of this is diverted into research and development.