On the Brink of a New Bull? – What Makes This Cycle Unique

Equity markets reached a new high for the year, adding to their recent gains ahead of the likely market-moving inflation reading and Fed rate announcement this week. While stocks are still a ways off their record highs, the S&P 500 is up about 20% from its mid-October lows, a threshold that could indicate a new bull market.

The rally has been powered by enthusiasm around artificial intelligence (AI) and a resilient economy that has defied expectations for a slowdown in the face of higher interest rates. But central banks are taking notice, with the Reserve Bank of Australia (RBA) and the Bank of Canada (BoC) surprising markets with more tightening. We offer our perspective on what makes this cycle unique and how it may play out in the second half of the year.

Longest bear-market rally, or one of the weakest starts to a bull market in history??

The path that markets have followed since October appears different from what tends to happen around major inflection points when looking at duration and strength. If we remain in a bear market, at eight months since last year's low, the rise in equities would mark the longest bear-market rally in history (the average bear market rally has lasted about two months).?

On the flip side, if we have entered a new bull market, the 20% rally would mark the second-weakest start to an upcycle going back 100 years (the S&P 500 has gained 38% on average during the first eight months of a new bull). Also, this would be the only bull market since 1980 that small-cap stocks have not outperformed large-cap stocks.?

In our view, the more favorable turn in inflation and the gradual shift in central-bank policies suggest that this is not a prolonged bear-market rally and that the October low might not be revisited. But at the same time, it is likely premature to sound the all-clear. Some form of an economic slowdown is still possibly ahead of us, even as the foundation of a new bull market is likely already formed.?

Small-cap stocks show signs of life as tech takes a breather

During the early stages of a bull market, the "average" stock, as proxied by the equal-weighted S&P 500, tends to outperform the market-cap weighted index. Similarly, small-cap stocks, which are sensitive to economic growth, tend to outpace large-cap stocks. This year market leadership has stayed very narrow, with just a handful of mega-cap stocks accounting of most of this year's gains. To gain confidence about the lasting power of the rebound, broader participation is needed. On that front, June brought some encouraging news. As the tech and communication services sectors paused briefly to digest their sharp year-to-date gains, the traditional cyclical sectors and small-cap stocks have stepped up to fill the void.

BoC's June hike a reminder that the fight against inflation is not over

Last week, a main highlight was the BoC's surprise rate hike. After being the first major central bank to pause its hiking cycle back in January, the bank raised its policy rate by a quarter point to 4.75%, the highest since 20011. The catalyst for the shift was a resilient economy, the still-tight labor market, and even a rebound in the interest-rate-sensitive housing sector, all of which can prevent inflation from returning to the 2% target.?

The main takeaway is that the BoC and other central banks want to ensure that monetary policy is sufficiently restrictive, and they aim to achieve some type of landing (an economic slowdown) to tame inflation.?

Is the economy immune to higher interest rates?

Like Canada, the U.S. economy has been remarkably resilient to the Fed's aggressive rate hikes. Housing activity has cooled, and the manufacturing sector is under pressure. Yet, consumer spending, which is the main engine the economy, has been able to power through higher prices and interest rates, supported by strong job creation and higher incomes.

Does that mean that central banks are only getting started and will need to keeping hiking to bring supply and demand into balance? We don’t think so, as pandemic distortions have made this economic and market cycle unique by delaying (not cancelling) the impact of higher rates. We'd pinpoint three factors that continue to boost spending, though their effect is fading:?

1. Accumulated savings?– Households built a cash cushion of about $2.1 trillion between March 2020 and August 2021, aided by a drop in spending during the first year of the pandemic and by government stimulus2. Since then, consumers have been dipping into savings to sustain their increased spending. We estimate that about $900 billion, or 40%, of those excess savings remain, which at the current pace could support solid spending growth for the remainder of the year2. However, the leftover savings could be concentrated among high-income households, who are less likely to spend them.
2. Pent-up demand for services?– As many of us that have traveled recently can attest, spending on services (e.g., restaurant, hotel, airplane bookings) has jumped and is expected to stay robust through the summer as consumers make up the lost ground. However, at some point, pent-up demand will be satisfied, and consumption growth will slow. During the most recent earnings season many retailers noted some weakness in discretionary categories, which could be an early sign that the consumer might be starting to pull back.
3. Tight labor markets -?A wave of early retirements and lower immigration during the pandemic contributed to labor shortages that have not yet been resolved. While total employment is higher now?than it was before the pandemic, certain sectors, such as leisure and hospitality, have not yet fully recouped all the jobs that were lost. The labor market remains tight, as job openings continue to exceed the number of unemployed. But we see early signs of normalization as job quit rates, hours worked, and wage growth are all starting to move lower while jobless claims rise.

All eyes turn to inflation data and Fed meeting

With equity-market valuations closely tied to changes in interest-rate expectations, the upcoming CPI release and FOMC meeting are likely to set the tone for the remainder of the summer.?

Further moderation in inflation can help calm some nerves after the unexpected hikes from the RBA and BoC. Expectations are for headline CPI to fall meaningfully from 4.9% to 4.2%, helped by lower energy prices. For perspective, WTI oil averaged close to $110 in May 2022 vs. $71 this year1. But the focus will be on the core index, which excludes the volatile categories of food and energy, and is expected to show only a modest improvement, falling to 5.3% from 5.5%.??

The surprising strength in the labor market and the economy more broadly will keep the Fed on high alert against letting its guard down too soon. But after more than a year of aggressive rate hikes and 10 months of disinflation, we think that policymakers can afford to take a more patient approach. The Fed may hold off on hiking rates this month for the first time in more than a year, but signal in its statement and new projections that it may raise rates again if data warrants it. A June "skip" instead of a "pause" and one final hike in July is possible. But the weaker growth that we anticipate down the road will likely pave the way for the central bank to move to the sidelines through the remainder of the year.?

A strong handoff to the second half

Heading into the year, our view was that balanced portfolios were likely to experience above-average returns in 2023, though with elevated volatility, which we have yet to see. The soft-landing scenario remains alive, as consumers have kept the economy out of recession. But as time passes, the impact of high interest rates will likely be felt, and growth could weaken, as some leading indicators suggest. While an economic slowdown would be a reason for measured caution, it would also help inflation come down, supporting a Fed pause.?

No two cycles are the same, and this is certainly the case for the current one, which has been impacted by pandemic distortions, high inflation and aggressive rate hikes. While it might be premature to enthusiastically embrace the developing bull market, history shows that some of the best days happen during the early phase of a new upcycle, arguing against trying to time the pullbacks. We would view any renewed phase of volatility in equities as an opportunity to position for a more sustainable rebound that is likely to have broader shoulders than what we have currently seen. We recommend investors stay close to their. strategic, long-term allocation for most asset classes that make up a well-diversified portfolio, including bonds which offer historically attractive yields.

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