Surveys in the US indicate that business optimism and the pace of economic growth are most likely peaking. With the US unemployment rate at only 3.8 per cent, fast approaching the lowest level seen in the last 50 years, economic growth should naturally slow as the economy starts to run out of workers who are available and sufficiently trained to fill the increasing number of job vacancies.
There are currently over 6.5m unfilled job openings in the US, the highest level on record. The percentage of people who think it is hard to get a job at the moment has fallen to 15 per cent, the lowest level since 2001.
To keep growing at the pace it has been, the US needs either more immigration or an increase in worker productivity. But, the political environment has clearly shifted in favour of less rather than more immigration.
Productivity growth, getting more output out of existing workers, could be the knight in shining armour which comes to the rescue. Business investment intentions surveys give some hope that a potential rise in productivity is a possibility. However, this has historically been remarkably rare, with productivity growth tending to decline when unemployment rates are low, with the notable exception of the late 1990s.
So while a productivity pickup is a possibility, it may not materialise in a meaningful enough way in time to save this economic cycle. If so, growth rates will likely peak soon.
With US corporate earnings growing by 24 per cent year-on-year in the latest quarterly reporting season, helped by the sugar rush of tax cuts, it is also almost inevitable that the pace of US earnings growth will peak this year. Even excluding the effect of tax cuts, US companies will probably struggle to continue to grow earnings at the strong pace they currently are.
In the eurozone, unemployment has more room to fall than in the US, and earnings are rising off of a lower base. As in the US, business surveys suggest the pace of growth may have peaked, but the economy will grow less quickly rather than contract in the coming months.
Key points
- The US economy needs either more immigration or an increase in worker productivity to keep growing at the same pace
- A peak in the pace of growth need not be bad for equity markets
- What were the warning signs of past bear markets?
Still high consumer confidence suggests that equities have not yet peaked. Eurozone data has been disappointing relative to expectations since the start of March. However, since 2005 as long as the economy does not head into recession and the data merely stops disappointing by as much as it has been, eurozone equities have always made gains over the next six months. This suggests that while the political situation in Italy poses some downside risks, eurozone equities probably have not peaked and are most at risk from an eventual US recession dragging them lower.
With US economic growth and corporate earnings peaking, is that a reason to fear that January’s high for the S&P 500 was the high point for this cycle? If we look at the previous cycle, the pace of US economic growth peaked at the end of 2003 and then slowed pretty consistently all the way into the recession in 2008.
Despite the pace of growth peaking in late 2003, US equities did not peak until October 2007. So clearly a peak in the pace of growth, need not be bad for equity markets, as long as the economy continues to grow.
Investors also worry about the peak in the US Institute for Supply Management’s (ISM) surveys as they have historically been a good lead indicator for growth. The ISM manufacturing survey peaked in February at 60.8, consistent with very strong growth, and has since fallen to 58.7, consistent with still healthy but slightly less strong growth. Since the 1950s, once the ISM manufacturing survey hit 60, the S&P 500 made gains nearly 70 per cent of the time over the next six months.
Historically, the peak in equity markets, has normally required not just a slowdown in growth but for there to be a recession on the horizon within the next year. The flash crash of 1987 is the only equity bear market since the 1970s that was not followed by a recession within a year. While medium term recession risks are clearly rising as interest rates rise, the probability of the US entering recession by this time next year remains quite low given that the boost from the US administration’s fiscal stimulus is only just beginning to filter through into the economy.
So if peak economic and earnings growth are not signals for a peak in equity markets, what were the warning signs of past bear markets? In both of the last two, the conference board’s leading economic indicator peaked before equity markets. The three month average of initial jobless claims troughed at or just before the point at which equities peaked.
The conference board’s measure of consumer confidence also peaked around the same time as equities and was falling sharply by the time equities entered a bear market. At the moment, these economic indicators are not suggesting that US equities have already peaked.
When the facts change, we should change our minds but not until then. With the unemployment rate at such low levels and wages and interest rates rising, the probability of a US recession at some point in the next two to three years seems pretty elevated. However, with the economic data still positive it is probably too early to call the peak in equities just yet.
Mike Bell is global market strategist at JP Morgan Asset Management
