Domestic markets managed to broadly rise in the week ending on spooky Friday the 13th with the S&P500 notching progress of +0.2%; so far in October the benchmark is up nearly +1.4% on top of what was a strong 3Q and another quarterly earnings season now upon us. US financial markets are now moving into the portion of the calendar where performance is often most favorable, and out of the season where it historically is weakest. This poses an interesting question: can the recent pace enjoyed over virtually all of 2017 continue or get even better over 4Q and 1Q, or was the seasonal benefit pulled forward to a degree that year-end will be uninspiring?
From an economic perspective and recent soft headline from the hurricane-influenced September employment report aside, data continues to support the view that the Fed will hike short-term interest rates one more time before 2017 sunsets. The strongest of themes is that we are witnessing synchronized global growth and that it seems to be accelerating. Surveys of US companies reflect continued supportive sentiment; industrial production in Germany surged +4.5% over the year-ago level while Taiwan exports and Japan machine tool orders accelerated 21% and +46% from same periods last year, respectively. The MSCI world reflects an +18% increase in the trailing 12 months. Those are crazy big numbers when thinking about economic activity occurring around the globe and go at least some distance toward explaining how the market continues to advance despite persistent negative and worrisome media headlines and providing a valid justification for why valuations appear at the higher-end of their historical ranges. But what these numbers also suggest is that inflation may be spooling up to quickly rise. And indeed, wages (a key ingredient to broad-based price pressure) appear to finally be showing a more meaningful increase via the Atlanta Fed wage tracker.
With commodity prices rising (attributable at least in part to rebuilding efforts following recent catastrophic weather) and wage-data also suggesting upward bias, inflation may be transitioning from sub-target to more concerning. This comes just as the term on current Fed chairwoman Janet Yellen looks set to end and the possibility of a more hawkish replacement is not remote. To the extent that price pressure rises too swiftly, the Fed would likely adjust its very metered rate normalization process into something more robust than markets have seen in over a decade. Hastening wage pressure would also put downward bias on corporate profit margins. Both of these factors would start the clock on how much longer the current business and market cycle can endure before a short-circuit occurs. As noted frequently, we believe there is more time this cycle and pent-up demand persists; but the long age of this bull market and economic expansion, coupled with what seems to be a growing complacency or calm over the markets has us on the watch for the streak without a correction to come to an end. The market has now went more than 335 trading days without so much as even a 5% correction; a long period of tranquility by most any measure. At the same time, a recent survey of the most bearish investors shows that even they are throwing in the towel on waiting for a meaningful pullback, which in itself may be one of the most troubling aspects of this current backdrop. A lack of bearishness, even in the absence of euphoria, suggests that market expectations may be too high and ripe for short-run disappointment.