Inflation is running below the Federal Reserve's 2% target, and given a lack of widespread leverage, Fidelity Investments says that the main ingredients for a bear market are missing.
In a recent blog post, Jurrien Timmer, director of global macro for Fidelity Management and Research, tried to calm nerves about the stock market heading into the New Year, given the market's strong run so far in 2017. There are concerns that there may be declines in 2018 as the long-running bull market starts to come to an end. But Timmer says that, in order for that to happen, there has to be rising inflation and high levels of leverage – or borrowing money to pay for assets on the part of companies and households.
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According to Timmer, rising inflation is the sign that expansion is coming to an end, while the amount of leverage in the economy can indicate how bad a downturn will be. High levels of leverage can result in liquidity crises that could turn a downturn into a severe event like a crash, wrote Timmer. Forced selling because of high leverage was one of the drivers of the 2008 financial crisis, he noted.
But with both of those things relatively low, investors don't have to worry about a severe downturn in the new year. In fact, it may be more of the same, which should be good news for stock investors. "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," wrote Timmers. He said that, if you assume the Federal Reserve is right and inflation will gradually increase to 2%, there will be no negative implications.
As for leverage, Timmer said that it has increased to 45% of GDP in the non-financial corporate markets, up from 40%. He also said that leverage has increased on the balance sheet of the central banks, government debts and bond funds. However, leverage in the financial and household sectors has declined since the financial crisis, with financial sector leverage moving 40 percentage points lower and household leverage reducing 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," wrote Timmers. "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."