This is the second installment in our “What If” series. The first, “What If [Insert Name] Wins the Election?,” looked at how elections influence market returns. As a reminder, these blogs are not usually our base case, but we consider the range of possible situations that could play out and address the “what ifs” we are talking about the most, and how they could change the trajectory of the markets.
What If the Markets Party Like It’s the 1990s?
Today’s current economic expansion and market rally have investors antsy that the party is coming to an end, but history tells us that expansions and associated stock market rallies can, and have, lasted much longer than most investors expect, particularly over the last four decades (Display). So what if the current expansion and rally persist for longer? They could. Let’s take the decades between 1980 and 2000 as an example.
The US market was up on average 17.5% every year in the 1980s. So when the recession hit in 1990, investors expected returns to be lower as they reverted toward the long-term average. Instead, the recession was shallow and brief. And what followed were even higher annual returns that surprised investors. Today, the economy benefits from cheap debt and strong employment whereas globalization, automation, and productivity gains drove the 1990s. And despite the nine-month recession that began mid-1990, the US equity market between 1980 and the end of the 1990s posted strong returns. Although we do not expect a recession in 2020, expectations for growth are quite modest. Could this year—like 1990—be a mid-point of the next economic expansion and accompanying equity market strength?
Running of the Bulls
Our research shows that the length of business cycles has increased over the years. Analyzing data going back to the 1870s, we see that recessions have become less frequent. In the 20th century, we’ve experienced a recession about a quarter of the time, but today, that’s fallen to just 8% of the time—and when they occur, they do so with lower drawdowns. At the same time, expansions have become longer—an average of 101 months vs. 44 months (Display).
The reason for this dramatic difference? Economic structural changes.
There are three structural shifts that we believe have contributed to the elongated cycle. First, the economy’s move away from goods toward services has reduced investment booms and busts. Second, monetary policy and an anchored inflation target have prolonged cycles. Finally, growth of debt levels and elevated asset prices have pushed more money into the hands of the spenders. Together, these have helped keep the expansion alive (Display). But they’ve raised other market risks.
Will Risks Take the Bull by the Horns?
These factors have increased the risk from policy errors and financial leverage. Policy risks have grown because the cycle is now more dependent on monetary stimulus, which is highly influenced by inflation. Getting these decisions right and not overshooting, or undershooting, is a delicate balance. Today, the Fed is basing policy on incoming data. But what if the data are extrapolated to indicate a trend when it’s actually a one-off anomaly, and policy adjustments overcorrect?
At the same time, financial risks are more pronounced—balance sheets for businesses and the government are more levered, and even though household debt is down, those consumers that have taken on debt are likely dependent on rising prices for homes, investments, or other large assets to keep their debt ratios low, or are reliant on the continuation of a low interest rate environment. If rates were to turn sharply higher and debt levels become too high relative to assets, then coverage becomes burdensome and can lead to defaults or other financial difficulty.
If either of these risks becomes overwhelming, then it could put an end to the expansion. But if the Fed does what many expect, which is to keep rates at the current levels, and asset prices remain rational while balance sheets stay strong, then history tells us that this expansion can continue to run. Additionally, with today’s low inflation, the economic pressures that may have existed in other cycles, don’t exist today. This would be supportive of equity market investing.
Our Base Case
We believe the US economic expansion will continue this year. We expect the US economy to grow 1.7%, slower than last year’s growth of roughly 2.3%, but importantly, we are not forecasting a recession in the next 12 months. And our base case for equities going forward is quite modest—7.2% over the long term. But what factors can change the course of our forecasts?
Today’s economic drivers are different than those of the 1990s. The 1990s’ expansion was characterized by the rise of emerging markets—like China and India—into global manufacturing bases powered by the interconnectedness of a new invention—the “World Wide Web”—and related substantial advancements in automation and productivity. Conversely, the current expansion has relied on cheap debt, a steadily decreasing unemployment rate, low inflation, and supportive monetary and fiscal policy. In the next 10 years, we expect to see growth from many possible areas, including innovation in communications, healthcare, and investment in infrastructure.
But several factors could change the trajectory of continuing today’s economic strength. The first is whether the labor market can remain robust and unemployment can persist at these low levels. Both of these are needed to keep consumer spending strong, and the economy growing. The second is whether exogenous factors—namely geopolitics—will impede business activity. And the last is how well the Fed can manage the economy and implement effective policies. If these factors can positively influence the economy, then the markets just may party like it’s the 1990s!
Our next installment in our series, which will examine the impact of geopolitics on the market, will be available late-February.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.