What could trigger a bear market?
Our chart analysts are rather uncertain about the future direction of the S&P 500 index. In any case, they expect a sharp fall in the index before too long. The only question is whether this will happen from the current level or only after a further rise of 10% to 15%. Incidentally, should the latter occur, it is quite possible that a correction will take place first. This could take the form of the market moving sideways for a while or a short-lived decline. Only then will the rise to new highs begin.
What concerns us most is the question of why, sooner or later, there will be a significant fall in the index. We believe the answer to this lies primarily in the US bond market. If the yield on 10-year US government bonds – currently around 4.45% – were to rise above 5%, this would create a much more negative environment for shares. This is all the more so given that the dividend yield on the S&P 500 index has fallen below 1%.
The next question is why the US 10-year yield might rise above 5 per cent. This would undoubtedly mark a significant moment for the bond market, as the 10-year yield has not really exceeded this level for over 20 years.
If we first look at monetary policy in this regard, the monetary conditions – the strength of the dollar, real interest rates, credit spreads and so on – still point to a loose monetary policy. This may come as a surprise, given that the Fed cut interest rates three times by 0.25% last year and subsequently indicated its intention to cut rates even further by 2026. The thinking was that interest rates were at a level where they were still holding back economic growth. It is also reasonable to assume that, given the fall in energy prices, inflation will fall again, which would push up real interest rates
On the other hand, however, contrary to expectations, consumers have continued to spend heavily and there is now an investment boom. Combined with a falling savings rate and low unemployment, this suggests that in the US the so-called ‘neutral rate’ – the interest rate at which the economy is neither stimulated nor held back – is clearly higher than was assumed a year ago. Particularly when looking at unemployment, it is quite possible that, with lower energy prices, economic growth could become so high that the labour market becomes too tight and wage increases accelerate. This is all the more likely given that Trump is increasingly attempting to shield American industry from external competition by means of import tariffs and restrictions. We expect that productivity growth will still be insufficient to prevent higher inflation.
The conclusion is therefore that the Fed will probably feel compelled to tighten monetary policy in the not-too-distant future. This will also push up the 10-year interest rate. That said, this is unlikely to happen immediately, as the fall in oil prices over recent weeks has pushed down inflation expectations. This will only change once it is recognised that it is precisely this factor that is keeping economic growth high.
A completely different issue regarding the 10-year US interest rate is the deteriorating supply-demand balance for capital. The US government continues to borrow enormous sums – particularly if interest rates remain high – and the investment boom also requires ever-increasing amounts of money. The same applies, incidentally, to the energy transition and the maintenance of higher stock levels.
All this is happening whilst the Fed is no longer buying bonds on a large scale but is selling them. Finally, an increasing number of countries wish to hold fewer US bonds. In China’s case, it has even gone so far as to want the yuan to become a much more prominent reserve currency alongside the dollar. Consequently, there is less capital available for investment in the US.
In this context, Japan and countries in the Middle East should also be mentioned. In Japan, interest rates are rising, making it less attractive to invest elsewhere, whilst countries in the Middle East need to invest heavily to reduce their vulnerability to the Strait of Hormuz.
Conclusion: a gradual monetary tightening and deteriorating supply-demand dynamics for US bonds make it quite likely that, before too long, the yield on 10-year US bonds – currently around 4.45% – will rise above the crucial 5% level.
A major uncertainty, however, is what will happen if, in the slightly longer term, productivity rises significantly as a result of AI. Will the economy then grow much faster, or will unemployment rise sharply as a result? The former could put upward pressure on interest rates, whilst the latter could put downward pressure on them. We will have to assess this when the time comes, but much will depend on whether or not share prices remain in a long-term uptrend.
