Bull market threatened by rising inflation and interest rates
The global bull market in stocks is now between two and a half to three years old. Despite the gloomy prognostications from bears, stock markets have continued to hit new cyclical highs over the past few months, thanks to a global economy that has surprised many with its resilience as well as stubbornly low interest rates. Looking forward, the question is whether the favourable conditions of the past few years will persist and continue to support stocks.
Recent data do not suggest significant weakening on the economic front. Forward-looking indicators continue to hold up well, with many even showing improvements.
Most significant of the latter are the purchasing managers' indices in the manufacturing sector. The global manufacturing PMI compiled by JPMorgan and NTC Research showed a sharp improvement recently, rising from 52.2 in August to 54.7 in September. This improvement was shared by a wide cross-section of economies, as reflected in the following table of national PMIs for the past two months.
The PMIs for the services sector were not as good. The ISM's non-manufacturing index, for example, fell to 53.3 in September from 65.0 in August. However, the CIPS/RBS index for the euro-zone rose to 54.7 in September from 53.4 in August. In any case, the indices remained above 50, indicating expansion.
Other indicators have also been positive. The Bank of Japan's quarterly Tankan survey found respondents generally positive on the business outlook in September, while in Germany, the Ifo institute's business confidence index rose in September.
About the only indicators that have tended to be negative are those for consumer sentiment. In the United States, where the consumer has been the engine of US as well as global economic growth, the latest readings from both the University of Michigan's and the Conference Board's measures of consumer confidence have been weak.
So the bears might yet be right. However, the bears might be right even if the economy is not quite on the brink of a downturn. Why? Because there is evidence that a stronger-than-expected economy may be bringing on higher inflation, which in turn may lead to higher interest rates. In the past, higher interest rates have more often than not signalled the end of bull markets, because firstly, they make equity valuations less attractive to investors and secondly, they hurt demand, which ultimately hurts corporate bottom-lines.
What evidence do we have of higher inflation? The US consumer price index for September was up 4.7 percent from the previous year, the biggest jump since 1991. In the euro-zone, the year-on-year inflation rate hit 2.5 percent in September according to a flash estimate, well up from 1.9 percent in January and the highest in over a year. Even deflationary Japan saw its core consumer price index fall just 0.1 percent in August from a year earlier, and land prices in Tokyo in July were actually higher than the previous year, the first rise in prices since 1990.
Of course, high oil prices are the main reason for higher inflation in most economies. And while oil prices had been moving higher for over a year on rising demand, the recent hurricanes in the Gulf of Mexico, which disrupted oil production, adds to the upward pressure on oil prices.
Not everyone is convinced that inflation is a threat, though. Some economists point out that outside of energy-related prices, inflation has been minimal. For example, despite the high headline inflation rate in the US in September, the core inflation rate, which excludes food and energy, was only 2.0 percent.
However, the Federal Reserve does not appear to be among those who are unconcerned with inflation. A number of Federal Reserve officials have come out over the past month or so stressing their concerns over rising inflation risk.
The minutes of the Federal Open Market Committee meeting on 20 September also show that the Federal Reserve appears more concerned about higher inflation than weaker growth. According to the minutes, in deciding to hike the target federal funds rate by 25 basis points to 3.75 percent, the committee was of the view that despite the devastation following the hurricanes in the Gulf, "aggregate demand and output would likely rebound before long". Therefore, "meeting participants were concerned that price pressures, which had been elevated before the storm, could climb further, primarily as a result of additional increases in energy prices".
It also pointed out that even after the latest interest rate hike, "the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required".
The European Central Bank is apparently similarly concerned with inflation. Although it kept interest rates unchanged earlier this month, ECB President Jean-Claude Trichet also said that the bank is showing "strong vigilance" against inflation.
With all this inflation talk, no wonder US 10-year Treasury yields, which had been as low as 3.9 percent in June, are now around 4.5 percent.
However, central banks can be wrong. In fact, many economists doubt that the strength of either inflation or economic growth is enough to justify higher interest rates. As mentioned earlier, indicators such as the core inflation rate and consumer confidence indices could quite plausibly be used to support such views. Betting on higher interest rates is far from a no-brainer.
Then again, if inflation is low because of a weak economy, that might not be good for stocks either. In such a situation, you might still need an uptick in interest rates to tip the stock market over. It is just that you might need less of an uptick.
The current economic expansion has surprised many economists with its strength and resilience in the face of rising consumer debt and global economic imbalances. The strong economy has helped corporate profits rise strongly as well and sustained the bull market in equities.
However, investors should keep in mind that, at this stage of the business cycle, the best part of the economic expansion is over for most economies. On the other hand, inflationary pressures appear to be building up. Under such conditions, a rise in interest rates might just be the straw that breaks the bull's back.
Recent data do not suggest significant weakening on the economic front. Forward-looking indicators continue to hold up well, with many even showing improvements.
Most significant of the latter are the purchasing managers' indices in the manufacturing sector. The global manufacturing PMI compiled by JPMorgan and NTC Research showed a sharp improvement recently, rising from 52.2 in August to 54.7 in September. This improvement was shared by a wide cross-section of economies, as reflected in the following table of national PMIs for the past two months.
| August | September | Change | |
| US | 53.6 | 59.4 | + |
| Eurozone | 50.4 | 51.7 | + |
| Japan | 53.8 | 54.5 | + |
| UK | 50.1 | 51.5 | + |
| China | 50.6 | 50.9 | + |
| Australia | 43.3 | 52.9 | + |
| Singapore | 52.2 | 53.1 | + |
The PMIs for the services sector were not as good. The ISM's non-manufacturing index, for example, fell to 53.3 in September from 65.0 in August. However, the CIPS/RBS index for the euro-zone rose to 54.7 in September from 53.4 in August. In any case, the indices remained above 50, indicating expansion.
Other indicators have also been positive. The Bank of Japan's quarterly Tankan survey found respondents generally positive on the business outlook in September, while in Germany, the Ifo institute's business confidence index rose in September.
About the only indicators that have tended to be negative are those for consumer sentiment. In the United States, where the consumer has been the engine of US as well as global economic growth, the latest readings from both the University of Michigan's and the Conference Board's measures of consumer confidence have been weak.
So the bears might yet be right. However, the bears might be right even if the economy is not quite on the brink of a downturn. Why? Because there is evidence that a stronger-than-expected economy may be bringing on higher inflation, which in turn may lead to higher interest rates. In the past, higher interest rates have more often than not signalled the end of bull markets, because firstly, they make equity valuations less attractive to investors and secondly, they hurt demand, which ultimately hurts corporate bottom-lines.
What evidence do we have of higher inflation? The US consumer price index for September was up 4.7 percent from the previous year, the biggest jump since 1991. In the euro-zone, the year-on-year inflation rate hit 2.5 percent in September according to a flash estimate, well up from 1.9 percent in January and the highest in over a year. Even deflationary Japan saw its core consumer price index fall just 0.1 percent in August from a year earlier, and land prices in Tokyo in July were actually higher than the previous year, the first rise in prices since 1990.
Of course, high oil prices are the main reason for higher inflation in most economies. And while oil prices had been moving higher for over a year on rising demand, the recent hurricanes in the Gulf of Mexico, which disrupted oil production, adds to the upward pressure on oil prices.
Not everyone is convinced that inflation is a threat, though. Some economists point out that outside of energy-related prices, inflation has been minimal. For example, despite the high headline inflation rate in the US in September, the core inflation rate, which excludes food and energy, was only 2.0 percent.
However, the Federal Reserve does not appear to be among those who are unconcerned with inflation. A number of Federal Reserve officials have come out over the past month or so stressing their concerns over rising inflation risk.
The minutes of the Federal Open Market Committee meeting on 20 September also show that the Federal Reserve appears more concerned about higher inflation than weaker growth. According to the minutes, in deciding to hike the target federal funds rate by 25 basis points to 3.75 percent, the committee was of the view that despite the devastation following the hurricanes in the Gulf, "aggregate demand and output would likely rebound before long". Therefore, "meeting participants were concerned that price pressures, which had been elevated before the storm, could climb further, primarily as a result of additional increases in energy prices".
It also pointed out that even after the latest interest rate hike, "the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required".
The European Central Bank is apparently similarly concerned with inflation. Although it kept interest rates unchanged earlier this month, ECB President Jean-Claude Trichet also said that the bank is showing "strong vigilance" against inflation.
With all this inflation talk, no wonder US 10-year Treasury yields, which had been as low as 3.9 percent in June, are now around 4.5 percent.
However, central banks can be wrong. In fact, many economists doubt that the strength of either inflation or economic growth is enough to justify higher interest rates. As mentioned earlier, indicators such as the core inflation rate and consumer confidence indices could quite plausibly be used to support such views. Betting on higher interest rates is far from a no-brainer.
Then again, if inflation is low because of a weak economy, that might not be good for stocks either. In such a situation, you might still need an uptick in interest rates to tip the stock market over. It is just that you might need less of an uptick.
The current economic expansion has surprised many economists with its strength and resilience in the face of rising consumer debt and global economic imbalances. The strong economy has helped corporate profits rise strongly as well and sustained the bull market in equities.
However, investors should keep in mind that, at this stage of the business cycle, the best part of the economic expansion is over for most economies. On the other hand, inflationary pressures appear to be building up. Under such conditions, a rise in interest rates might just be the straw that breaks the bull's back.
