- Strong economy has fueled prolonged bull market.
- Forecasters are concerned that current market and economic cycles are nearing an end.
- Indicators signal room for stocks to stay on track in 2019.
The U.S. economy continues to hum along quite nicely. Fueled in part by tax cuts, low interest rates and still-modest inflation, the economy advanced at an annualized pace of 4.2% in the second quarter,1 and an estimated 3.5% in the third. Forecasts for the fourth quarter anticipate still more solid growth, albeit at a more modest pace,2 in what is now the second longest economic expansion in history.3
The economy’s performance has helped support robust growth in corporate earnings, which averaged close to 25% year-over-year in the first half of this year, with full-year expectations slightly above 20%,4 both well above the long-term average.5 Investors certainly took notice, with the S&P®500 Index, a benchmark of broad stock-market performance, rising 7.9% year-to-date at the close of the third quarter. By some measures, this is now considered the longest bull market in history.6
All things must pass
The cold reality that we must remember is that bull markets do not last forever. Eventually, economic performance slows as capacity constraints emerge, central banks tighten monetary policy, corporate profit growth decelerates, and valuations become unsustainable. All of which begs the question: Is the October selloff in stocks a warning sign that stocks may struggle in the coming year?
Economic prospects going forward
The economy’s strength has been a fundamental factor driving the bull market, and it appears to be on solid footing, for now. We expect growth in the second half of this year to be close to 3%. Economic growth may slow a bit in 2019, but we believe it is reasonable to expect roughly 2.4% growth,7 since there remain plenty of fiscal stimuli in the pipeline. As always, there are risks, however. The increasingly intractable trade war with China may become more of a headwind in 2019, especially if the scheduled increase to a 25% tariff on the latest round of imports takes effect at year-end.
Additionally, although the production side of the U.S. economy is not yet at full capacity, the labor market tells a different story. In September, the unemployment rate fell to a five-decade low of 3.7%.8 So far, this has not driven a meaningful rise in wages or a corresponding increase in consumer price inflation. It may be only a matter of time, though, for wages and/or inflation to tick upward, especially since the demand for workers exceeds the available supply. The Federal Reserve has been raising interest rates at a methodical pace to prevent the economy from overheating and seems intent on continuing down this path over the next year. Bond markets have taken notice, as yields recently moved upward.
The economy’s strength has been a fundamental factor driving the bull market, and it appears to be on solid footing, for now.
Increasing challenges ahead for stocks
Prior to the recent October selloff, by a number of valuation metrics stocks were fully valued, if not expensive, and sentiment among both professional and individual investors was elevated. As a result, as the current cycle matures, stock-price gains may become more modest, although October’s declines have left stock prices closer to what we consider to be reasonable.
Next year, we expect the pace of corporate earnings growth to slow amidst a moderation in economic activity. Consensus expectations anticipate earnings growth of 10% in 2019.4 And while 10% earnings growth is still quite strong, it would nevertheless represent a meaningful slowdown to less than half the pace of this year.
Does the bull still have legs?
Most indicators suggest that both the current economic cycle and the bull market may be entering a more mature phase in which economic growth rates and stock price gains level off from the current pace. That does not necessarily mean that the bull market cycle is at risk of imminent demise. Rather, it suggests that the factors which typically conspire to bring about the end of a cycle are coming into view. Notwithstanding the recent selloff, we continue to have a modest preference for stocks over bonds, and U.S. stocks over most foreign equity markets. You may be well served to review your portfolio allocations with your advisor to ensure that they are well diversified and align appropriately to your own risk tolerance.