The Younger the Expansion, the Younger the Rally

February 16, 2018

The voracity with which US stocks have rebounded from the mini meltdown in the early part of February is explained in part by how the economic backdrop for the US remains positive. As of Thursday, the Dow had come close to recovering half of the value lost since January 26th.  Whether it gets back to that record high soon and if it can extend gains beyond that depends on how much life market participants believe remains in the expansion.

The notion that the US is late in its economic cycle is not a new one.  The last time there was negative year-over-year growth was in the final quarter of 2009. In other words, we have had 8 years of uninterrupted annual growth, though the US experienced two quarters in this period (Q1 2011 and Q1 2014) where the economy contracted on a quarterly basis. It is technically the third longest expansion since the Great Depression and if we get through this year without the start of a recession it will tie the 1961-69 period for the second longest.  Getting through to the middle of next year without one puts this expansion in the running to be a record. Even though this is doable, the fact is that we are much closer to the end of this cycle than the start, or the middle for that matter.

Investors who came late to the equity game (i.e., in the last two months) may have believed that the recent shockwave through stocks was the start of the next ‘big’ correction. However, episodes like 2008 and the 2000-2003 market declines tend to require either a recession or strong evidence that one is about to start. Put another way, the 10% hiccup in the Dow was the appetizer for a main course that is perhaps 1-3 years out. If so, investors need to look for market rallies that are younger than the US and this means going abroad.

Broadly speaking, there are the developed markets in Europe and the Far East and then emerging markets in these areas, as well as Latin America and Africa. Given the increased risk associated with the latter space, especially from a potential snap back in the value of the US dollar, I am going to focus on Europe and Japan.

 

 

As the previous chart shows, Eurozone GDP growth has steadily accelerated since around the middle of 2014 and, in year-over-year terms, it has outpaced the US for the past two years. In terms of duration, however, Europe is less than 5 years into this expansion.  That is not too far away from the average expansion length, but it is still much younger than the US expansion.  In relative terms then, Japan’s expansion is in its infancy, effectively starting in the first quarter of 2015. As of the end of last year, Japan had gone 8 quarters without a contraction in GDP.  That matches the period ending in 2001. On a year-over-year basis, Japan is currently about half of the length of its pre-2008 expansion.

Viewed in terms of equity market performance, the numbers don’t line up exactly with the relative economic expansions. Even with the recent jolt, the S&P500 is still up 300% from its post-crisis low in March 2009. Japan’s Nikkei, however, is up about 200% and this compares to only an 85% rally in Europe’s main equity benchmark. This would suggest there is much more room for European stocks to run, alongside further growth in the economy.

 

 

To be sure, all regions have their own particular risks.  In Japan, where central bank Governor Kuroda has been re-appointed, there is a remote chance that the bank will start applying the monetary brakes prematurely.  The other risk is that the Japanese yen continues to strengthen against the greenback, beyond Y100, which could squeeze growth. In Europe, the economy faces the challenge from BREXIT and also the risk that the European Central Bank begins to tighten policy too early. I would suggest these are still smaller than the risks facing the US from an exploding fiscal deficit, potential climb in inflation and higher interest rates, not to mention simply an old age expansion. You will notice, I didn’t mention Canada in this. Even though its equity market has lagged like Europe’s, it is also late in its economic cycle. NAFTA and tax policy won’t help either.

 

 

Upcoming events

Canada:  Wholesale trade, retail sales, CPI

US:  Existing home sales, FOMC meeting minutes, leading indicator,

 

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