Navigating the late cycle

The current expansion of the US economy has become the longest on record, while the equity market is enjoying its second longest bull run ever. The business and investment cycles do not always run in tandem, but this time they have much in common. The longer the expansion continues, the greater becomes investors‘ need for navigational guidance.

Using the “investment clock”

A useful aid here is the “investment clock”. This model splits the market cycle into four phases (see diagram). The process starts with a recession. A contraction of economic activity causes heightened uncertainty and losses on the financial markets. Central banks react by loosening monetary policy. As stimulus takes effect, the economy moves into a recovery phase. At first, central banks keep interest rates low to support the incipient upswing. On the financial markets, equity prices rise while credit spreads narrow and bond yields move up. As the expansion becomes broader and deeper, the cycle moves into the boom phase. As the cycle matures, equity markets continue to advance, but corporate bonds start to encounter headwinds. Monetary policy is tightened to avoid overheating.

The investment clock model is simple and clear, but it has a major disadvantage. It describes an idealised cycle and glosses over the uncertainties and complexities of the real world. The phases do indeed follow each other as described, but the dividing lines are fuzzy. At present, for example, monetary policy is still in expansionary mode, despite the fact that the equity market boom is now over ten years old. Notwithstanding these limitations, investors should keep the investment clock in mind when deciding how to position themselves.

Cycle approaching its end?

The investment clock helps investors ascertain where the markets are in the current cycle. But it is only a descriptive tool; it provides no direct guidance about when the next phase of the cycle will commence and when portfolio positions should be adapted. After a record 120 months of continuous growth in the US, there is little doubt that the expansion is at a mature stage, but that need not mean that a recession is on its way. A recession can be triggered by various factors. There are three main types of trigger, though recessions are often the result of a combination of multiple causes:

• Excessive capital spending by companies, leading to misallocations of capital and falling returns
• An abrupt change in monetary and fiscal policy, e.g. in response to inflation
• Problems caused by overvaluation of financial assets or heavy borrowing in response to over-expansionary monetary policies.

Viewed through the prism of these criteria, there are few immediate causes for concern, which is surprising in view of the length of the current expansion. Capital spending is subdued, the absence of inflation pressure makes monetary policy fairly predictable, and equity valuations are not excessive. The only downside is the high level of debt in the public sector and increasingly in the corporate sector too. The lack of more serious signs of aging is presumably due to the fact that the US recovery is the gentlest in post-war history, with average GDP growth of only 2.3% per annum.

Cycles are vulnerable to external shocks, which can knock the markets out of kilter and/or trigger a recession. Such shocks are by definition impossible to predict. Geopolitical risks have undoubtedly increased, notably as a result of trade warfare, Brexit and the Iran issue. Investors seem to have become inured to these uncertainties. Their increasingly blasé attitude increases the potential negative impact of surprises and shocks.

Contradictory signals from the financial markets

The markets themselves provide little help in navigating the cycle. The signals they provide are contradictory or opaque. The blame for this lies primarily with monetary policy. Central banks use various tools to steer the business cycle. What distinguishes their present behaviour from previous cycles is the extremely prolonged application of monetary ease. The Fed is the only major central bank that has moved away from a super-easy policy to a more normal stance. The European Central Bank and the Bank of Japan are still in crisis mode, with Japan having been in an ultra-expansionary rut for many years now. Exceptionally, the Fed has now said it is ready to reverse its rate hiking course if necessary. This has helped convince the markets that rate cuts are in the offing. But that will only happen if the US economy weakens significantly. The fact that the equity market is celebrating a possible easing of monetary policy while taking the economic slowdown in its stride suggests a firm belief in a soft landing. In this scenario the global economic slowdown would merely be a blip in a continuing expansion.

The equity market’s optimism is not shared by the bond market. On the contrary, yields on long-term US Treasuries have fallen below yields on short-term money market deposits. Many market participants are worried about this, because every previous US recession has been preceded by an inversion of the yield curve. In fact, however, the current pattern of interest rates does not indicate that the end of the cycle is just round the corner. In the past it has taken about two years for a yield curve inversion to usher in a recession.

The discrepancy between the bond and equity markets is highlighted by their movements so far this year. Despite flagging corporate earnings growth, the equity market has posted a double-digit advance. Yields on US Treasuries, by contrast, have hit historic lows. The close relationship between economic growth and bond yields suggests that this is a danger signal. Optimists attribute the discrepancy to the fact that different drivers are at work. While the equity market is driven by real-term global growth, the government bond market is guided by inflation expectations. But the corporate bond sector is also more sceptical than the equity market. Credit spreads have been widening gradually for over a year now. This points to an end of the expansion, whereas the US equity market is still flying close to its all-time high.

Difficult navigation

The business and financial cycles are both at an advanced stage. The fundamentals are not flashing red, but the signals from the markets are unclear and contradictory. Investors should not let themselves be lulled into a false sense of security. It is ten years since the last crisis, but the countermeasures taken at that time continue to reverberate or – as in the case of Europe – are still in operation. Established models like the investment clock are being distorted, and the same goes for many cyclical indicators. The situation is further complicated by overriding factors such as demographic change which affect prices, demand and productivity. Added to that is the threat of deglobalisation, which jeopardises the assumptions on which economic policy and corporate behaviour have been based for several decades.

Risks typically intensify in mature phases. But past experience shows that it pays to stay invested. In previous cycles the US equity market has advanced by 39% on average during the last 24 months before the end of a bull run, with a 27% gain in the bull’s last 12 months. We therefore see no reason at present to bail out of the market. Nevertheless, investors should be careful about their positioning:

• Surging debt and the rapidly growing number of lower-quality borrowers make the credit market vulnerable, even though low yields currently provide support. We recommend caution towards low quality corporate issues – either the risks are too high or the compensation too low.
• The outlook for equities at this late stage of the cycle is much better than for the credit market. However, given the handsome gains already achieved and the current weakness of the economy, a relaxed attitude would be unjustified. We recommend a cautious positioning.
• Government bonds have been a reliable portfolio stabiliser in the past. But in view of this year’s fall in yields and their current absolute low level, we prefer diversification by means of other asset classes.
• At this advanced stage of the market cycle, investors should ensure that their portfolio is not over-exposed to risk. This applies especially to cyclical investments. Gold, market-independent hedge fund strategies and insurance-linked securities are useful for hedging purposes.
• Individual companies can be a high-risk investment in a mature market. Company-specific risks may be underestimated and growth potential overestimated, making such companies’ securities especially liable to correction.

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Author: Bernd Hartmann, Chief Strategist of VP Bank

This content is preface of the quarterly publication "Investment Views".