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The missing ingredients for a bear market

Without excessive leverage or inflation, a bear market seems unlikely.

  • By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
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Key takeaways

  • Historically, rising inflation often forces the Federal Reserve (Fed) to raise interest rates, to the point of inverting the yield curve and eventually causing a recession.
  • Once an economic expansion ends, however, the amount of built-up leverage (debt used to buy assets) in the financial system typically helps determine how bad a subsequent downturn might be.
  • At this point, with inflation running well below the Fed's 2% target and a lack of widespread leverage, we’re not seeing some of the makings of a nasty bear market.

In my view, the 2 key drivers that will signal when the US expansion and bull market are ending—and how bad any subsequent downturn might be—are inflation and leverage (debt used to buy assets).

The emergence of inflation in the late stage of an economic cycle typically forces the Fed's hand in terms of the speed and magnitude of its rate-tightening cycle. If inflation pressures become bad enough to force excessive rate hikes, what often follows is an inversion of the yield curve—when the interest rates on shorter-maturity bonds rise above rates on longer-maturity bonds. History suggests this typically curtails the availability of credit, which eventually (6 to 12 months later) causes the economy to contract and a bear market to start.

A lack of inflation can mean an extended Goldilocks environment for stocks, with growth and low inflation, as has been the case for some time now. If this changes, it may mean that the Fed will have to seriously tighten financial conditions. Low borrowing costs have been 1 of the 2 powerful tailwinds (the other being strong earnings growth) propelling stocks higher since the 1st quarter of 2016, so a reversal of that tailwind would be a striking development.

If inflation reveals whether an expansion is going to end, the amount of leverage in the system might indicate how bad the subsequent downturn could be. High levels of leverage can lead to forced selling and a liquidity crisis, which turns an ordinary downturn into a crash. Forced selling helped create the kind of severe downturn we saw during the 2008 financial crisis.

So, where do these 2 drivers stand today? Inflation remains very low, so unless it sharply accelerates from here, it's unlikely to turn the ongoing expansion and bull market into a contraction and bear market.

Of course, this also depends on the speed and magnitude of the Fed cycle. One way to illustrate this is to compare the "real" federal funds target rate (using core consumption expenditures prices, excluding food and energy) to the so-called "natural real rate of interest," or "R*." R* is the rate that would keep the economy operating at full employment and stable inflation. (You can read more about R* and how it is calculated from the Fed). A Fed easing cycle tends to drive the real funds rate down to well below R*, and a tightening cycle tends to produce the opposite effect.

This can be seen in the chart, where the shading shows the difference between the real funds rate and R*. Leading up to the dot-com peak in early 2000 the real rate was several percentage points above the natural rate. That was enough to invert the yield curve and eventually cause a bear market for stocks. The same thing happened in 2007, in the run-up to the global financial crisis.

So where are we today? Fortunately, right now the real policy rate is pretty much equal to the natural real rate, leaving the system in balance. If we assume that the market (via the fed funds forward curve) is correct (pricing in a 2% rate in 2 years) and that inflation will gradually rise to 2%, that will still leave us at a 0% real rate in 2 years, which is where R* is right now. So no harm, no foul, if the market is correct.

On the other hand, if the Fed's so-called "dot plot" (a graphic depicting all 16 Federal Open Market Committee members' individual projections of where the policy rate will be) is accurate, there will be 7 more rate hikes, plus the effects of a projected $1.25 trillion decrease in the Fed’s balance sheet. Then the funds rate could be closer to 4%, which would be +2% in real terms. If R* is still at 0% then, it could be enough to cause a downturn. However, my view is that the Fed will only go there if R* is trending higher. This is how I am thinking about the whole Fed cycle.

Leverage
The next chart is an attempt to illustrate where the so-called leverage "bubbles" are. It shows the change in borrowing over time, expressed as percentage points relative to gross domestic product (GDP). It shows changes in corporate leverage, household leverage, financials sector (banks) leverage, and government debt.

I also show the change in the Fed's balance sheet (as a percentage of GDP), as well as US bond mutual funds and ETFs (which added $1.2 trillion in flows, arguably as a consequence to the Fed's policies). I realize that these are assets and not liabilities, but I am trying to show the various potential air pockets out there. To many pundits, this is where the bubbles are these days.

What can we learn from this chart? A few things. Leverage in the non-financial corporate sector has recently increased from 40% of GDP to its previous cycle highs of 45% in 2000 and 2007. There is also plenty of leverage in central bank balance sheets (+20 percentage points of GDP since 2009), government debt (+37 percentage points since 2008), and bond funds (+11 percentage points of GDP). However, leverage in both the financials and household sectors has declined since the financial crisis. Leverage in the financials sector is down roughly 40 percentage points, while household leverage is down some 20 percentage points.

When I add it all up, I do see pockets of excess leverage but certainly not a widespread excess. Plus, it should be remembered that neither the central banks nor the government will likely be forced to sell anything. Why is this important? Because in 2007, there was a massive buildup of household, financial sector, and corporate leverage that all had to unwind during the financial crisis. It was a catastrophic trifecta of deleveraging. We don’t have those same conditions presently. We have government debt, corporate debt, and a much larger Fed balance sheet (which, some people argue, drove bond buying by the public), but those are offset by a significant deleveraging in household and financial sector debt.

The bottom line is that with neither inflation nor widespread leverage present in the system, I do not believe we have all the ingredients for a downturn in the economic cycle.

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