May 22, 2014
Fifth Third Private Bank
  Markets and economies have natural rhythms and cycles. We have recently argued that many of the long term cycles that set the general pace of multi-decade economic expansions have turned from "vicious to virtuous," that is, from burdens to growth to benefits. But what of the shorter-term trends that dictate the experience of investors over a three to five year horizon? As the U.S. economy enters the fifth year of expansion, and stock market investors continue to benefit from new highs, there is a natural tendency to ask, "When will this end?"

In the following piece, Jeff Korzenik, Fifth Third Private Bank's chief investment strategist explores those questions and others. I have also included a link to our quarterly video that I encourage you to watch to find out more.

I hope you find these pieces helpful. Please contact me with any questions; it is a top priority for me to keep you informed on the market in general and about your personal situation.

 
   
  A Question of Maturity
By Jeff Korzenik, Chief Investment Strategist, Fifth Third Private Bank

At Fifth Third Bank, we have long argued that the age of bull markets and economic cycles should not be measured by the calendar. An exodus from a recession typically continues as long as there are no impediments to continued growth. A high unemployment rate, an apparently low utilization of our industrial capacity, and a central bank determined to err on the side of keeping interest rates low, all suggest that U.S. growth will continue. In fact, given the rising confidence among both consumers and business decision makers, Fifth Third continues to believe that U.S. GDP growth will not only continue, but will likely accelerate.

It is always possible that exogenous events could halt the U.S. economy's improvement. Harsh weather conditions clearly impeded growth in the first quarter, but a spate of positive economic news has confirmed that this was only a passing slowdown. Geopolitical risks frequently move headlines, but short of full-fledged major wars, tensions or minor conflicts rarely move financial markets or impact global growth. Currently, international conditions are generally conducive to global growth; European economies continue to heal from the European Monetary Union financial crisis, Japan experiments with reform, and the magnitude of the emerging market slowdown is insufficient to cause a global problem, but sufficient to spur productive economic reform agendas in those nations.

Seventh Inning Stretch
If we are clearly not at the end of our economic expansion, where are we in the business cycle? The consensus of the investment industry places the U.S. economy squarely in the middle. At Fifth Third, we see some evidence that we are somewhat past this midpoint. With the baseball season upon us, we'd use the analogy of our being in the 6th or 7th inning of the game.

In our view, labor markets and industrial capacity are "tighter" than traditional metrics would suggest. Skill mismatches and the tragically high number of long-term unemployed have raised our estimation of the level of structural unemployment in the United States. Industrial capacity is overstated given the age of our factories given the increased reliance of manufacturing If we are indeed in a more mature stage of the market, investors have new opportunities as well as risks. Positives would include new market leadership as cyclical companies gain pricing power and corporations accelerate capital investment. The current boom in mergers and acquisition is both evidence of a later-stage market, and a likely source of return for equity investors for some time to come.

Inflation Equation
Evidence that the market may be more mature heightens our sensitivity to attendant risks. First and foremost, we are closely monitoring for the inflationary forces that arise in the latter half of a cycle. An initial pickup in inflation would clearly be welcomed by the Fed, which has wrestled with the demons of deflation and seeks to restore wage growth. Peak market valuations are also historically associated with inflation above today's levels.

Rising inflation can ultimately pose a danger to equity investors as it may prompt the Fed to tighten monetary conditions. However, we must stress that this is a distant scenario. An initial pickup in inflation would first allow the Fed to normalize interest rates, a welcome development for savers with little negative consequence for economic growth. The march from today's extremely loose monetary policies to neutral and then to tight conditions is likely to be measured in years, not quarters.

Bond investors, however, must not be complacent. Yields currently do not fully reflect the traditional relationship with growth and inflation. An accelerating economy and a pickup in inflation argue for higher yields and lower prices for fixed income. While bonds still hold distinct advantages over sitting in cash, investors in this asset class must be proactive in maintaining diversification and limiting the maturity dates of their portfolios.

The business cycle is but one of the many recurring patterns that drive economic activity. Investors should keep in mind that many long-term trends have turned from burdensome (vicious cycles) to beneficial (virtuous cycles). Among these helpful trends are a demographically-driven housing boom, the end of a deleveraging cycle, the reshoring of manufacturing and the U.S. energy boom. The turn of these long-term trends in our favor is not guarantee against recessions, nor will they resolve all the structural economic challenges we face. However, while investors must always be aware of the short term risks, in our current environment, they would also do well to keep in mind the many long term positives ahead.