What Could Turn Bull to Bear?

In a recent story, we saw that, contrary to popular thinking, the present bull market is not the rise of a new 2-year old bull market, but rather the last frantic gasp of an older, 12-year bull run. If so, what lies ahead that could bring it to a stop?

A vigorous post-pandemic recovery is underway, but it is not signalling a new bull market, thinks Craig Basinger, chief investment officer at Richardson Wealth. The pandemic crash and recovery have only been a “pause” inside a larger ongoing bull market that started in 2010. It’s like a beach ball in water, likens Aidan Garrib, head of global macro strategy and research at Pavilion Global Markets. “The coronavirus pandemic pulled the beach ball below the surface, he says, and with the recovery, that ball is shooting up into the air, but in reality, the ball is still in about the same spot where it was before 2020.”

A 2-year old bull market simply doesn’t behave as markets presently do, Basinger and Garrib argue. At the beginning of a bull run, investors are cautious, market direction is unclear, and equity issuance is low. Presently, risk appetite is red hot, IPOs and SPACs are popping up everywhere, and indices are constantly reaching record highs. All these signs point to the end of a bull cycle, not its beginning.

Basinger and Garrib don’t say that this bull is headed for the slaughterhouse tomorrow. Present conditions are still favourable, and the beast still has room to run. In fact, “I think it’s safe to say that chances of a recession in the next 12 months are low, says Basinger. And if there is a pullback, we think it will be a buying opportunity.”

Inflation, the Beginning of the End…

But what will herald the end? “Inflation and rising yields,” answers Basinger. But more specifically, it is when inflation will prompt central banks, essentially the Federal Reserve, to turn hawkish and raise rates to rein in inflation. “Central banks will respond by dialling back quantitative easing and eventually hiking rates, Basinger continues. And given how markets are hooked on low rates, it will unravel the bull.”

As long as central banks remain dovish, and inflation remains tame, then the bull should keep running. Well, maybe not, warns Garrib: “We’re in a world where this dovish stance itself could end the bull cycle.”

The difference rests in the type of inflation we will have in the coming period: will we witness demand-pull inflation or cost-push inflation? “Central banks love demand-pull inflation, explains Garrib. You have strong demand, consumers are buying, and companies are capable of passing on their higher costs to consumers.”

…On the Other Hand

However, cost-push inflation is another story. “It erodes earnings, Garrib continues, as costs grow faster than prices, and these cost pressures can cause companies to have a harder time to pass on costs to consumers.” That leads to cost-cutting, companies reluctant to hire, prompting the recovery to stall.

Many parts of this scenario seem to be presently playing themselves out. For example, in the key sector of home building, activity in Canada and the U.S. is presently slowing down even if mortgage rates remain unchanged at rock-bottom lows. When looking on a year-to-year basis, states Garrib, construction inputs have risen by 23%, on a 2-year basis, by 17%. “It is concerning that sales of smaller homes are declining sharply, as rising input costs make the price per square foot less appealing to buyers.”

Global factors are also playing in the mix. “Companies are starting to reconfigure supply chains to make them more robust to shocks, observes Basinger. While this is good, it is likely not as cheap, contributing to cost-push inflation. Longer-term, the disinflationary pressures of globalization are slowing. And demographics too are softening on the disinflationary side as the inflationary impulse from millennials rises and disinflationary baby boomers fade.”

The pressures presently building, especially in housing, help explain the recent ‘Fed speak’, notes Garrib. “Fed officials are bending over backward, trying to promise continued accommodation, while also sounding more hawkish on the timeframe for tapering. They are trying to balance easy-financial conditions with a stronger dollar to temper the commodity price gains hurting manufacturing and housing.”

Softening the Blow

But the shock of that moment will very much depend on how the central banks initiate their rate hikes, believes David Sekera, chief U.S. Market Strategist at Morningstar. In the U.S., he expects the Federal Reserve “will give a lot of forewarning to markets before it changes its monetary policy”. At each quarterly meeting, it will announce a modest implementation of a long-term tightening policy. For example, next Fall, it will say that it should start tapering its monetary policy at the beginning of 2022. In December, it will probably announce that the new year will see it start to slow down its present monthly bond purchases at the rate of US$ 10 to US$ 20 billion a month.  Slowly. Softly. Gently. “The earliest rate hike will maybe happen at the end of 2022, more probably at the beginning of 2023,” Sekera adds.

A rate hike is not an issue for Sekera, though he does not exclude two possible exogenous shocks to the economy: a new lockdown phase in response to the delta variant of the coronavirus, and a more pronounced slowing down of China’s economy than what markets have already priced in.

So, barring a trauma coming from the left field, this bull could still ride, though, at a more leisurely pace, Sekera expects. “We think the U.S. market is trading at a 4% premium right now, which is at the high end of the fair value range. The market has probably overextended itself, prompting us to expect muted returns in the second half of 2021, compared to the 15% increase in the first half.”