Trying to predict the end of economic cycles isn’t an easy game, but analysts at Morgan Stanley believe that they have some idea as to the date of the current bull market end.
In a research report published last week titled, Cycle Check-Up: How Will the Bull Market End? The bank's leading strategists pull together the historical data to try and put together an end of cycle playbook for investors.
However, while the team believes that some features define the end of every cycle, they don't think that the current cycle is likely to come to an end anytime soon as conditions remain favorable.
When Will The Bull Market End?
Morgan's propriety 'cycle indicator,' which is based on the analysis of multiple economic data points, concludes that the current cycle still has room to run, but it is in the late stages. Still, this is positive for equities as they tend to outperform at towards the tail end of cycles:
"A late-cycle environment is usually good for equities. Looking at optimal portfolio allocations through the last 30 years, we find that the best portfolios during 'expansion' are equity-heavy (but HY-light), suggesting that a high allocation to stocks is still warranted as long as the cycle is intact. In fact, unsurprisingly, there's a strong cyclical pattern to optimal allocation: exposure to stocks is highest in early cycle ('repair'), falls as the bull market ages, and troughs in 'downturn'; allocation to bonds goes the other way."
The big question is: how will the bull market end?
Based on the analysis of past cycles, Morgan's analysts point to the three "X's" that tend to cause trouble around late-cycle "eXtreme leverage build-up, eXuberant sentiment and eXcessive policy tightening."
Trying to determine if any of these risks are present today, is not easy. For example, there's some evidence of excessive leverage in the corporate sector, but overall the US is much less levered than it was before the 2008 crisis. The ratio of US aggregate debt/GDP has trended sideways for the past two years as the fall in public, household and GSE leverage has been more or less offset by an increase in corporate debt. (As shown in the chart below, a doubling of government debt is almost entirely responsible for the growth in overall debt levels) .
Meanwhile, there are some sections of the market dominated by exuberant sentiment although overall, conditions are calm:
"While, say, US consumer confidence is near all-time highs, and the share of negative economic surprises has been climbing (that is, market optimism has run ahead of disappointing reality), we've also yet to see the extreme reallocation flows from bonds to equity funds comparable to past cycle peaks."
The one unknown factor here is "eXcessive policy tightening." We will only find out if this is a risk as the Fed unwinds its balance sheet over the next year. According to the portfolio managers at the Odey Odyssey Fund, the combined unwinding of the ECB and Fed balance sheets will translate into a " decreased supply of savings...equivalent to an annualized 1.3% of at 2017 World GDP at the end of 2018 and 1.6% at the end of 2019." In the US, the incremental call on private savings would be 68% of current federal borrowing in 2018 and 97% in 2019 and 2020, which, with nominal GDP growing at 3.8% at present, "implies either zero real growth."
This call on savings won't unfold overnight. Morgan's analysts expect the monetary policy tightening to unfold over the next two years:
"We are not that early in the policy cycle as some would argue – on median, the 24-month run-up to the end of the cycle sees the Fed hike rates by ~180bp in real terms; we're already on 100bp. And on our economists' forecasts of hikes and PCE, over the next 12 months, we'd have seen 190bp hikes in excess of inflation over a two-year period, taking us closer to the typical end-of-cycle policy environment."