That could be the point when consensus opinion tilts toward the notion that the ingredients for a self-sustaining recovery are in place. And because GDP growth has been slower than average coming out of the last recession, five years into the recovery the nation still has considerable slack in the labor market. This sets up a scenario where the economy can continue to make steady GDP gains for some time before driving up labor costs to levels that could trigger meaningfully higher levels of inflation.
The third reason I think this bull market has legs is that interest rates are likely to remain low for at least another year.
Capitalism begins with capital, and recapitalizing the banks was an important part of the economy’s healing process over the past five years, when many banks and other financial institutions were in peril. The spread between what banks pay on deposits and what they receive on loans—their net interest margin—rises as the yield curve steepens. The Federal Reserve’s monetary policy has kept the yield curve steep by essentially setting the short-term interest rate at zero. This has allowed community, regional and money center banks to absorb write-downs of bad loans while, in effect, reloading their capital reserves for the next upsurge in consumer and commercial demand for credit. With an improving economy, banks have seen a steady decline in non-performing loans (and reserves set aside for those bad loans), which has helped fuel their profitability.
Low interest rates have also helped individuals refinance existing loans and repair household balance sheets. While aggregate consumer debt levels remain high, household debt service as a percentage of disposable income has fallen below 10%,4 its lowest level in 35 years. Low interest rates have enabled investment-grade companies to issue debt to finance expansion or, in many cases, to increase dividend payments or buy back their stock to increase per-share profits.
With the market not expecting the Federal Reserve to begin raising interest rates until 2015, 2014 could well shape up to be another healthy year for earnings and dividend growth in the U.S. Finally, low interest rates impact the multiple that investors are willing to pay to own stocks and even the percentage of stocks investors own in their overall portfolio. With the dividend yield on the S&P 500 at nearly 2% (higher than what investors can get paid from owning a 5-year Treasury), competition from Treasury notes remains muted for investors searching for income on their invested capital.
In the end, what typically ends bull markets are impending recessions. In the next part of this series, we’ll look at what the last two recessions had in common, and why a recession in the next 12 months remains a low probability.
1This refers to the combination of information that impacts how earnings per share and dividends per share are expected to behave. Information thought to decrease either earnings or dividends typically yields a negative impact, whereas information thought to increase either earnings or dividends typically yields a positive impact.
2Source: S&P Dow Jones Indices for the S&P 500 Index from 3/31/2012 to 3/31/2013.
3Source: Bloomberg, with data as of 12/31/2013.
4Source: The Federal Reserve Board’s Household Debt Service and Financial Obligations Ratios as of most recent update, 12/31/2013.
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