Looming threats to the bull market
Last weekend's news of Iran's 99%-intercepted missile and drone attack on Israel did not rattle the stock markets, although the risk of escalation pushed gold to new highs (not to mention other drivers of gold, such as ever increasing public debt levels).
Although we are currently living in a bull market, fueled by a global economy that is strong in some areas (e.g. the US) and warming up from stagnation in others (e.g. the eurozone, China), it is never a waste of time to speculate about the risks. Turnarounds cannot be predicted, but they can be prepared for. While we don't know where the peaks will eventually occur, we can try to sense where we stand in the cycle now, as billionaire investor Howard Marks has put it.
Stock markets around the world are approaching or have already gone well beyond previous peaks. Pricing multiples look generous in some areas. For example, the S&P 500 is trading at nearly 21 times its estimated earnings in a year's time, compared with a typical P/E ratio of 15-18x over the past decade.
In order to continue the positive trend in global equities (and the budding bull market on Nasdaq Helsinki), earnings growth must also continue. Earnings, in turn, are linked to economic development.
The world economy is driven by the United States, because its households are the biggest source of demand for the services and goods produced in the world. In the US, the strength of economic growth has been impressive. The service sector in particular has remained hot (a major part of the economy is made up of services), while the industrial sector appears to be picking up speed based on purchasing managers' indices.
Unemployment is at a near-record low. Inflation is persistent and far from the central bank's target, but still under control.
However, there are small cracks in the shield of the "Captain America" of the global economy. For example, in small-business confidence surveys, so-called "hard data" such as intentions to employ and invest are plummeting. Depending on the source, small companies employ 40-50% of US employment.
Wage inflation, as tracked by the Atlanta Fed, is decelerating rapidly. In principle, this is good news, as strong wage growth also fuels overall price increases. But it may also be a symptom of a rapidly cooling labor market. In fact, the number of job postings on the Indeed index is also dropping like a rock.
Contrary to popular fears, the rapid rise in interest rates in 2022 did not hurt the economy, at least not immediately, except for some debt-ridden real estate investors. The economy has been booming. But how long can the debt-laden US economy sustain high interest rates? For example, the average interest rate on new mortgages is back at 7%, while the average home price relative to the median income of Americans is at a record high. Housing prices have not collapsed because most of the indebted owners are locked into the previous low interest rates, but how long can the current situation last if new buyers cannot afford to buy?
The US 10-year bond rate can be seen as the "gravitational force" of the global economy. It’s an investment that offers almost risk-free returns. The current level of 4.5% was more commonplace in the early 2000s. Equity valuations don't always clearly follow interest rates, as a high interest rate environment also reflects strong economic growth. But if interest rates are high enough for long enough... something in the system can break down.
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China, the world's second-largest economy, is notoriously struggling to grow: air is hissing out of the real estate bubble, local governments, companies, and households are up to their ears in debt, and the country's investment-led growth model is no longer able to deliver profitable investments. Familiar problems, but instead of worrying, stock markets (except for China's own collapsed stock market) are shrugging off China's problems. Since the Communist Party and the central government can sweep problems under the carpet with an iron fist and reallocate economic resources as they please, the mainly domestic debt mass will not be allowed to reach crisis point.
It’s impossible to predict the development of societies (and economies), and even more difficult to monitor the dynamics of authoritarian countries from the outside. But what if the rest of the global markets' assumption that China can cushion the impact of crises with endless borrowing turns out to be wrong? As a friend of mine once said, "The hangover will come, but I decide what day it will be". How much hair of the dog can one consume without the liver bursting or the money running out? Even the liver of the Chinese economy has its limits, no matter how rule-breaking the authoritarian command economy may be.
China is a major player in the global economy. Although China's GDP is about 18% of the world's GDP, it accounts for 35% of the world's industrial production. That's as much as the next 10 countries combined. China accounts for about one-third of investments. However, because of China's uneven economy, it accounts for only 13% of global consumption. This means that the significant slowdown in China will not so much hurt global demand, but especially investment goods and raw materials. In a recession, countries with high levels of overproduction and weak domestic demand tend to bear the brunt. In addition, China accounts for a tantalizing one-fifth of the revenues of the major companies in the export-driven eurozone.
In addition to the economic problems, it’s difficult to say in the longer term whether the party is trying to distract people from domestic problems by venturing abroad.
While in the West, a similar debt mass and real estate bubble, coupled with a series of bad investments, would likely trigger a financial crisis, in China a slowdown in economic growth and the digestion of decades of malinvestments are more likely than a rapid collapse. But collapse is not inconceivable if the Communist Party's grip on power weakens. The Soviet Union was also eternal, until it simply ceased to exist.
