For some time now we have been making the case for a long-term bull market in U.S. equities. This has rested on the prediction of a gradual economic recovery devoid of inflationary pressures, played out against a very accommodative monetary backdrop. So far, this is exactly what has occurred. But as we all know, trees don’t grow to heaven and nothing lasts forever. Therefore the relevant questions we ask ourselves every day are: (1) what could go wrong and (2) when should we start to worry? We shall devote this quarter’s Outlook to the things we worry about.
Primary among our concerns would be a sudden and unexpected pick-up in inflation. So far during this recovery there has been enough slack in the U.S. economy, especially in the labor markets and in terms of capacity utilization, that the recovery has not sparked wage and price inflation. The deep recession in 2008/2009 drove unemployment up and capacity utilization down. Now, however, after over five years of slow but grinding recovery unemployment has dropped to levels that historically have triggered wage inflation, and capacity utilization has jumped back close to its historical average (Figures 1 & 2). There are now scattered reports of labor shortages and wage pressure in certain professions, such as welding, but these instances appear to be industry- and geography-specific and not yet generalized. A recent report noted that new jobs created since the 2008 debacle pay 23% less than the jobs lost in the downturn.1Regardless of its accuracy, this statistic is consistent with anecdotal reports of lower- and middle-class economic stagnation and financial stress continuing despite the economic expansion. If, when and how fast labor markets may tighten is a key risk. Our bet is that it’s a ways off and not a sure thing in the next 12-18 months. Continue Reading »