Could This Be A Bubble Again?

The economy is slowing, enough for the Fed to reconsider three rate hikes this year. Yet, the S&P 500 is up again on Friday. And the unemployment rate is 4.3% despite new job numbers falling compared to April. Sure, we have good demographics, and we have a global recovery story that is still intact. But after a roughly eight year bull rally, when do we take some serious risk off? Taking risk off the table has proven to be a major opportunity risk for RIAs and their clients. The market keeps going up.

A further rate hike is more likely than not in the June 24 Fed meeting. The Fed is looking to take interest rates to 3.0% by 2019. This assumes no stock market crash or recession, which many global investors are now saying is a bold assumption. The Fed believes that its QE program worked. Naysayers believe it just kept economies on life support. Taking that support away will be a problem. When that day occurs, a market correction is imminent.

The average U.S. real GDP growth rate since 2009 is 2%. Inflation remains subdued and the Fed’s preferred inflation gauge eased in the latest data to 1.5%. Inflation expectations in the Fed’s consumer surveys and market-based measures of inflation expectations are declining.

Bears have been predicting the QE crash for at least two years now. Most of us not very good at predicting major breakdowns in the cycle. Besides, there are too many new risks in the market. Cyber-attacks, the growth of shadow banking particularly in China and the increasingly digitalized nature of financial market infrastructures leave open the possibility of new and unknown kinds of systemic risks. The increasing relevance of non-banks and digital innovation (think China and its newfound love for bitcoin) might harbor new risks, especially given that some of these activities are outside the existing regulatory perimeter.

The disconnect between financial asset prices and what is happening in the major economies remains wide and is becoming wider, says Neil MacKinnon, an economist for VTB Capital. “The Fed is in danger of being caught out by late-cycle monetary tightening at a time when inflation might be stalling,” he says. “Previous ultra-loose monetary policy has already set in train bubble-type conditions, and history tells us that bubbles always burst.”

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