Market Stumbles Show Traders Already Think We're Late-Cycle

(Bloomberg) -- Maybe Caterpillar was right. What if this is as good as it gets?

The industrial bellwether's famous grouse, of course, referred to its own earnings. But signs are mounting that the sentiment might apply more broadly, that current cycles for everything from financial assets to credit conditions and even the economy itself are at or near the peak.

How else to explain why stocks have barely budged as companies notch the fastest quarterly growth spurt since 2011 and merger activity spikes to multiyear highs? Oil at a 2014 peak might suggest robust economic growth, the same way 10-year yields touching a four-year high could. Debt covenants have gotten looser and U.S. high-yield bond spreads are not far from the post-crisis low struck in January, which could indicate credit markets are in the later part of their cycle. At the same time, inflation's running hotter than it has in years.

Taken together, those otherwise impressive stats have started to unnerve market watchers, more of whom are saying it's time for investors to get used to the idea that, after nine years of economic expansion and a similarly aged bull market in equities, the party is going to start winding down.

“I'm convinced we are late-cycle,” Cantor Fitzgerald Global Chief Market Strategist Peter Cecchini wrote in an email last week, citing a proprietary model that said that at the beginning of 2018 there was a year or a little more left before a bear market. “As volatility picks up, it's my view investors need to be more tactically oriented,” he said.

There's evidence debt market players are orienting themselves for a shift in the credit cycle. Managers of collateralized loan obligations are shortening the CLO life and repricing the transactions to fine-tune deal terms to their benefit. At the same time, the biggest CLO buyers have weakened safeguards that limit how much risk they can take, amping up the potential pain for investors if the economy slows.

If that sounds a lot like 2007, there are reasons it need not set off alarm bells, Morgan Stanley's Andrew Sheets said. Late cycle doesn't mean the next step is straight down, he said.

“The next market phase is likely not going to be something that's severe,” he said in an interview Thursday. “It's going to be kind of a choppy, volatile down market,” and “in some ways, that can be more difficult because just being short might not work either.”

There are other differences compared with the past two downturns, including the threat of a trade spat and potential upheaval from U.S. midterm elections.

“Exacerbating the problem now is the impact of tariffs on downstream industrials, so the cycle feels a bit different this time,” Cantor's Cecchini said.

Not everyone thinks it's time to hunker down. In March, JPMorgan cross-asset strategist John Normand and senior U.S. economist Jesse Edgerton said they are still recommending a cyclical portfolio, including overweighting equities versus bonds and credit, while markets are in what they termed the “twilight of the mid cycle.”

And Cantor's Cecchini cautioned that “it's important not to get too bearish too early at the turn.”

As of late March, Wall Street strategists are sticking to their optimism as well. The median year-end forecast for the S&P 500 was 3,000, according to estimates compiled by Bloomberg. That would represent 13 percent upside from Tuesday's close on the benchmark gauge.

Still, there's no doubt that investors have a lot of potential focal points for their worries.

We're seeing a “peak in central-bank balance sheets and further tightening by the Fed, plus a potential peak in U.S. earnings revisions and earnings momentum,” Morgan Stanley's Sheets said. Also “a number of measures that have good longer-cycle predictive power, like consumer data, are pretty stretched.”

“It's a number of smaller things converging,” Sheets concluded.

--With assistance from Adam Tempkin Elizabeth Fournier and James Crombie

To contact the reporter on this story: Joanna Ossinger in New York at jossinger@bloomberg.net.

To contact the editors responsible for this story: Tracy Alloway at talloway@bloomberg.net, Jeremy Herron, Eric J. Weiner

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