Updating the cycle

As macro investors, our team has been acutely aware of the extent to which the world economy is slowing. We are at the late stage of the economic cycle, and the investment implications of a recession could be profound. Unlike life, cycles don’t end through old age. Instead, expansions typically die from policy tightening designed to slay the economic excesses at the time, such as high inflation or over-levered consumers.

In recent years, the monetary stance in the US has been one of tightening to slow excessive economic activity fuelled by tax cuts and to guard against inflation exceeding the Federal Reserve’s target. This policy appears to have worked. Whilst tax support for consumption has filtered through the economy, higher market interest rates raised borrowing costs.

Crucially, inflation has not risen sustainably above target levels, despite a seemingly tight labour market. However, US policy has caused end of cycle indicators such as the US yield curve to flatten. Also, manufacturing – the lead cycle sector – has entered a recessionary environment around the world as trade-war risks, auto-emissions regulation and Brexit, to name a few drivers, have impacted. This had knock-on negative effects on business confidence and investment.

There are also concerns across a range of emerging economies with USD borrowings. As their currencies weakened against the dollar, their ability to service debt via local currency revenues has been reduced. China’s move to prioritise a more sustainable consumer-driven economy away from an industrial-led one, has also seen growth slow, compounded by a weak credit impulse. Given China’s size, this has impacted the other major economic blocs.

With headwinds to growth raised, and underlying inflation falling or contained in many economies, monetary authorities have been given a green light to loosen overall monetary conditions. We are now seeing the most coordinated global easing cycle ever, but one that has its limitations.

Many macro metrics are benign at present suggesting an elongated cycle is possible

One reason for monetary policy limitations in the developed world is that, bar Canada and the US, very few have needed to raise interest rates far off the zero-floor in this cycle. Hence, very few have the fire-power to ease monetary policy aggressively now. Alternative monetary easing via restarting or introducing QE has not yet been deemed necessary, but this may just be a matter of time.

However, this hasn’t mattered for a few reasons. Firstly, market interest rates around the world have fallen to record lows, and in Europe to more negative levels, as investors anticipate a material disinflationary slowdown ahead. Even in emerging economies, where real interest rates had been kept high to defend domestic currencies, inflation has fallen far enough to allow some loosening of policy.

Secondly, governments have an ability to turn on the fiscal taps following years of retrenchment after the last downturn. Arguably, fiscal policy should have been kept loose as most governments can easily fund their deficit. However, the growth impact of fiscal loosening can be notoriously slow. It can take years to plan infrastructure spending, whilst sporadic “sugar rush” tax cuts can be short-lived and create economic distortions. Government spending is usually a sticking plaster for underlying growth issues within an economy, because history suggests where there is sustained public intervention, it is deployed inefficiently and could possibly crowd out the private sector.

Thirdly, despite all the doom and gloom in industry, it is not as important for overall output as in previous business cycles. Looking at the service sector (typically 60% or more of developed economies’ output) or consumption and employment, suggests most of the world’s economy is growing reasonably robustly. In the US, for example, lowered mortgage rates are helping the housing sector. Market interest rates for both consumers and businesses are also low. This has lessened the interest rate burden as loose credit standards and greater availability of credit aids the monetary transmission mechanism. In addition, employment is still rising in most economies.

Fourthly, leverage has moved off the consumers’ balance sheet onto sovereigns, and they are much more able to deal with the consequences. According to the Bank of Japan, for example, the amount of outstanding Japanese bonds and bills held at the central bank is just over 43% of the total outstanding at the end of Q1 2019¹. Most of this was purchased via its QE program since 2012 (when the percentage was 10%).

Hence, it appears the balance of the slowdown is presently skewed towards old economic sectors, that are perhaps less productive, but more visible and cyclical. We believe that as long as disruption from tariffs is limited and consumer confidence maintained, the world economy can keep growing sufficiently strongly, in aggregate, to avoid a deep recession.

This cycle is different

The analysis of this cycle doesn’t end there, though. The unusual characteristics highlighted above have been partly driven by the nature of the last recession. Consumer and corporate deleveraging, low investment spending and poor productivity in the labour market have resulted in a cycle that had the weakest nominal and real growth recovery on record. Combined with the poor demographic backdrop, this suggests the bias, in any slowdown, will be towards loose policy for an elongated period, with the constant aim of reflation.

Arguably, following the recent fall in market interest rates, some investors have already discounted a slowdown. Increased volatility across all asset classes also shows that the risk premium needs to be higher than just a few years ago. Central banks and governments are attempting to loosen monetary and fiscal policy to insulate their economies from the slowdown in industrial activity that is contaminating economies around the world. If corporate profits don’t fall and consumer don’t balk, a soft-landing is more likely over the next two to three years. But with a world economy much impaired, we believe the risks of something worse are high.

The investment implications could be stark. Contained market interest rates seem likely. That doesn’t stop short-lived sell-offs, but it does suggest flatter and/or lower interest rate curves. Further interest rate falls can cause equities to re-rate higher, if corporate profits don’t slow too aggressively. If trade disruption is minimised – the EU have just signed a number of free-trade deals, for example – and corporates keep their share of the economic pie, then equities can keep rising. However, the likely returns will be low, as equities are not particularly cheap.

As fund managers, we make investment decisions for the next 2-3 years to achieve our return target but have an equally important maximum risk target for our portfolios. With economic risks high, investing in the current environment won’t be easy and pin-pointing opportunities will be even more crucial to adhere to our mandates.

Investors will likely rely on carry or an interest rate premium to be a large part of their total return going forward. With USD15trn of the world’s sovereign bond market having a negative yield, investors’ appetite for income won’t wain. Selective higher-yielding credits such as US high yield, emerging market debt such as Mexico or South Africa or currencies such as the cheaply valued Yen or US dollar may be a source of superior return in this environment. In our view, some Asian stock markets and long-dated sovereign yields offer uncommon value at present as well.