The financial crisis of 2008 triggered the deepest recession and market downturn since the Great Depression. In March 2009, a bull market began its painful rise from the ashes. While the first few years of the expansion were marked by anemic economic growth (which caused great distress in political, business and academic circles), the American economic engine eventually began humming more normally.
In the past couple years, we have witnessed economic expansion at a rate some had thought we would never see again. That growth has resulted in ever more ebullient capital markets. Indeed, we have been experiencing a “bull market in everything” virtually unprecedented in history. Since the start of the bull market, the stock market has quadrupled.
While some analysts and commentators have been calling the top of the market for a while, it has kept testing new highs. But the voices of worry have been getting louder and more strident. This week, Merrill Lynch added its voice to the naysayers. Chief Investment Strategist Michael Hartnett has issued a major warning about the future of capital markets in light of shifting economic conditions and tightening monetary policy.
Merrill seems to think the great bull market may have finally run its course. Let’s take a look at their arguments.
Fed turns hawkish
Merrill’s Hartnett sees tightening monetary policy as a chief driver of faltering investment returns:
“The Fed is now in the midst of a tightening cycle, ignoring structural deflation, focusing on cyclical inflation. Until this Fed hiking cycle ends, we suspect absolute returns from financial assets will remain slim and volatile…Excess liquidity has been wonderful for asset prices: US junk bonds have annualized an 18% return, US equities a 19% return since their 2009 lows. US equities are on course to outperform US Treasuries for a seventh consecutive year, the longest streak since the 1922-1928 period.”
Hartnett’s concerns are understandable. Governments across the developed world are engaging in winding down quantitative easing policies that ballooned to levels without any historical precedent during the last crisis. The current bull market is the longest in history, but its longevity may be as much a product of that loose monetary regime as it is of strong economic fundamentals.
As monetary policy is tightened, central banks are working in largely uncharted territory. The risk of the unknown has rarely been so apparent. It is thus all the more concerning to Harnett that the Fed’s current leadership is engaging in a far more aggressive rollback of tight monetary policy than had been expected. That aggressive policy, Hartnett warns, will be, “the most likely catalyst for fresh losses across asset markets.”
Chinese influence and the specter of trade war
Interest rates are not the only thing Merrill thinks will trigger the end of the great bull market and exacerbate economic and financial instability. China, and its relationship with the U.S., will also play a role in choking off the bull run.
China’s growing influence over the global economy poses political challenges for the U.S., as well as financial concerns in the U.S. and across the developed and developing worlds. A currency crisis has already kicked off in parts of the emerging markets. The fear of contagion could spread further, disrupting advancing economies such as India.
Tensions between the U.S. and China have been mounting on a seemingly daily basis, as President Donald Trump continues to ratchet up his rhetoric and threaten ever greater tariffs. The Chinese have not been cowed, responding in kind. Fears of a trade war have loomed since Trump’s accession to the presidency. Those fears have only grown in recent months.
Thus far, the trade conflict has only been felt at the edges of the domestic economy. But if it persists, or escalates further, the pain will become far more apparent. Harnett is unequivocal in his concerns, going so far as to proclaim the mounting trade fight as the “first stage of a new arms race between the U.S. and China.”
A new arms race between the world’s two largest economies (which happen to be deeply economically interconnected) could spell disaster for consumer confidence, and faith in the security and stability of capital markets.
What investors can do about it
Investors do not just want to hear about problems. They want solutions. So what can they do to respond to the economic storm clouds threatening the bull market and the global economy?
Hartnett, Merill’s chief strategist, does not leave his readers hanging. Indeed, he offers a few concrete recommendations for investing in the face of looming chaos. He is particularly bullish on global defense stocks and companies that are attached to the national security apparatus. These “national security champions” offer investments in companies that tend to thrive in times of political turmoil and that always perform better when the U.S. is worried and spending big on security.
We have provided similar advice in the past, when we recommended Kratos Defense & Security Solutions Inc. (KTOS) as a worthwhile growth play in the sector. Investors can also always put their money into the aristocrats of the aerospace and defense sector, such as Lockheed Martin (LMT), Raytheon (RTN) and General Dynamics (GD), for a somewhat more conventional and conservative play.
Overall, things are looking somewhat grim on the horizon, even if the stock market remains outwardly confident and enthusiastic. These clouds might yet part, but investors would be wise to prepare for the less pleasant alternative.
Disclosure: I/We own no stocks discussed.
