Investing in a late cycle

This economic cycle will shortly be the longest on record, but a recession seems unlikely to occur in the next 12 months. In this article we look at potential investment opportunities this late in the cycle.

Global output is set to expand for a record 10 consecutive years in June. While growth in some regions has slowed in that period (for instance, Europe in 2012 and China in 2015), the strength of the US economy has kept the world out of a recession so far.

Economic data, such as leading indicators, the yield curve or real rates, suggest we are late in the cycle but not yet close to a recession. Furthermore, real rates remain relatively low by historical standards (see below), being barely positive in the US while still negative in most other regions in the developed world.

Real rates relatively low

US interest rates chart

The shape of the yield curve, which was much talked about in the second half of last year, was back in the headlines in March as the yield on 3-month bonds exceeded 10-year bond yields so inverting the curve.

Past episodes of yield curve inversions would suggest that risks of a recession in the next 12-18 months are high. We would discount this indicator in the current environment. The yield demanded by bond investors to tie up money in long-maturity bonds is extremely low and quantitative easing artificially compressed the spread between the short-end and the long-end of the yield curve. In any case, an inversion of the yield curve still suggests another recession is at least a year away.

Recessions are usually triggered by central banks raising interest rates to keep inflation under control while pushing real rates above the economy’s real growth potential, by extreme structural imbalances in an economy or a combination of both. With major central banks likely to raise interest rates more slowly than had been expected towards the end of last year and no imminent signs of imbalances tilting the economy into recession, we believe it is too early to exit financial markets due to recession fears.

Those worries are likely to create more volatility. Any set of adverse economic data would likely push markets to start pricing a recession, as happened last December. However, from an investment perspective, it is generally more costly to be too early exiting markets ahead of a recession than exiting too late. So if it pays to stay invested, what performs well at this stage of the cycle?

How to invest late in the cycle

Before delving into specific developments for equities and fixed income markets in the current cycle, it is useful to have a broad understanding of what this stage of the cycle typically means for asset class performance in general.

History tells us that commodities, inflation-linked bonds (ILB) and emerging market bonds tend to do well while investment grade debt (or credit) usually underperforms other asset classes.

The historically positive performance of ILB is partially linked to the rise in commodity prices, notably oil prices, as strong demand outpaces supply. This increase in commodity prices looks less likely this time around considering the supply/demand dynamic in oil markets. That said, a short-term increase in commodity prices due to geopolitical tensions cannot be ruled out.

Switching from passive to active strategies in equities

While no two economic cycles are the same, equity markets typically perform relatively well up to the very end of the cycle. As such, we believe it is worth staying invested but being more selective about exposure to equities rather than doing so through passive benchmark investments.

Volatility tends to flare up sporadically and financial markets constantly reassess the risks of a recession. This suggests investing with a quality bias, to select companies that can better withstand volatile episodes.

Another angle is to look at “growth” companies, especially those exposed to secular growth, such as healthcare and software. The more cyclical part of the equity markets (such as autos and semiconductors) are more at risk late in the economic cycle. In this cycle, with central banks providing ample liquidity and more investors invested in riskier assets than usual, the difference in the performance among sectors and stocks has been lower than the norm.

This trend is likely to reverse at this late stage of the cycle. As the investment environment shifts and price dispersion intensifies, active strategies may make more sense than index investing. Similarly, strategies aimed at minimising the risk of sharp downturns in markets may have more of a role to play.

Adjusting to the end of a bull market in fixed income

As mentioned earlier, market dynamics at this late stage of the cycle are rarely identical. In past decades, bond market performance was substantially influenced by a bull market driven by a prolonged downward trend in interest rates.

In recent years the bond markets have finally approached the 0% mark and, in the case of 10-year German bunds, still trade close to that level. The most common pattern late in a cycle, however, is inflation. As wages are driven higher and the commodity market can’t cope with the strong demand. This latter factor is less likely to happen at the moment.

Persistent elevated inflation levels generally favour emerging market (EM) bonds. The majority of EM countries are net exporters of energy and commodities and improving fiscal balances should generally support flows into their respective markets.

But not all countries are equal. While Brazil and Russia are the most prominent profiteers, Turkey and India are among the net importers. EM bonds are usually well positioned at this stage of the cycle for a different reason. In this phase, the hiking cycle of central banks approaches its peak, helping to support EM capital inflows.

Although credit is not the most natural harbour during this period, price volatility for high-grade bonds should be limited as the risk for default or large downgrades looks relatively low by historical standards. At the same time the pressure of further rate hikes is easing. Furthermore, a peak or consolidation in rates would start to work in favour of holders of medium to longer dated high-grade bonds.


Market Perspectives April 2019

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