Late-cycle investment strategies
This month the ongoing US economic recovery became the second longest on record and, if the trend persists into late next year this one could be the lengthiest ever. Americans may have reason to celebrate but some investors are growing concerned about the end of the business cycle — which often goes badly.
Historically, equities take a nose dive when the economy shifts from expansion to contraction. Meanwhile, global bourses are still trading within a few per cent of their all-time highs.
While I currently see few signs of an imminent downturn, this expansion clearly falls on the longer side of the historical averages. The “Great Recession” of 2008 and 2009, was the last economic contraction. Back then, growth went decidedly negative with America’s unemployment rate soaring to almost 10 per cent and the iconic Lehman Brothers investment firm filing for bankruptcy.
Since mid-2009, the US has enjoyed more than 8˝ years of positive real gross domestic product (GDP) growth, surpassing what is now the third longest recovery which occurred during most of the 1960s.
Expansions are defined as periods of positive GDP progress while recessions are defined by two consecutive quarters of negative real GDP growth.
The longest economic expansion lasted 120 months from 1990 to 2000, coinciding with the longest post-World War II bull market. Towards the end of that run, the Fed hiked interest rates a bit too much, leading to the stock market “tech wreck” in 2000 which led to the 2001 recession.
Bull markets tend to follow upturns in the economy and this one is no different. The current bull has so far lasted 110 months with the S&P 500 stock index climbing 291 per cent since its nadir in March of 2009. By comparison, the average bull market has lasted only 61 months with S&P index climbing 174 per cent, on average.
This extended bull run in the face of major new geopolitical uncertainties has some investors on edge. While economic expansions and bull markets do not necessarily die of old age, business cycles remain a fact of life and a case can be made that this one is living on borrowed time. Digging deeper, however, I see a number of cross currents in both the economy and the markets. But they are not all bad and some unique facets of this recovery suggest an extended mid-cycle period.
In terms of potential trouble spots, geopolitics appears as a major risk. Front and centre are the ongoing trade tensions between the US and China. Additionally, America is dealing with a perhaps unprecedented level of political volatility in Washington which periodically weighs on market sentiment and may be discouraging business investment. Meanwhile, rising interest rates, the withdrawal of monetary stimulus or “quantitative tightening” by the Fed and renewed tensions in the Middle East have made the future somewhat less certain.
Negative news makes headlines, but many positive factors are also in play. While short-term interest rates are on the rise in the US, longer-term rates remain relatively subdued with the 10-year Treasury bond trading at just over a 3 per cent yield. While much has been made of the bond yield recently breaking through the psychologically significant 3 per cent level, this yield is still lower than the average level seen between 2008 and 2011. Of course, inflation is perking up as energy prices rise, but at around 2 per cent it’s hardly a barn burner. In fact, a bit of inflation that includes some wage growth may be welcome in this environment.
Furthermore, while monetary stimulus may be slowly unwinding, President Trump has bet on juicing growth through $1.5 trillion in tax cuts and more government spending. Indeed, restrictive monetary policy is being offset with expansive fiscal policies.
And on the trade side, so far Trump’s talk of major tariffs has resulted in more benign policies than initially feared. With China’s average tariff on imported American goods at 10 per cent versus America’s average tariff of only 3.7 per cent on Chinese goods, we think there is room to negotiate.
While the length of this expansion is impressive, the strength is anaemic by historical standards. This time around, new regulations have forced banks to massively recapitalise, making them safer, while credit has been extended only frugally. For this and other reasons, US real GDP growth has averaged just over 2 per cent during the past eight years compared to an historical post-recession average of 4.3 per cent.
Arguably, the slow and steady pace of this recovery has created a firmer foundation than past boom-bust cycles.
Playing the late game requires agility. The winners and losers of each cycle may be a bit different, but the rules tend to be relatively consistent. The early part of an economic recovery phase is typically characterised by low interest rates, low inflation, spare manufacturing capacity, slack in the workforce and lean business inventories.
As the business cycle matures the opposite begins to unfold. Inflation and interest rates creep higher, capacity utilisation rises, employment grows and inventories rise. During the mid to late stage of the recovery, basic materials, technology, capital goods, transportation and certain financial-services sector equities tend to shine. However, investors need to be careful with bonds in this phase as rising interest rates reduce the price of most fixed-income securities.
Towards the end of an economic expansion and into the early part of a recession, the winning investment strategy begins to look quite different. With demand falling off, inflation declines as interest rates level off or start to decline. In this part of the cycle, defensive stocks such as food, drugs, cosmetics and healthcare tend to outperform. Longer-duration bonds typically to do well at this point, as do stocks which act as bond-proxies, such as electric and gas utilities.
Global investing is further complicated by the fact that different countries and regions may be experiencing different stages of their own business cycles. For example, we see many emerging markets as being closer to the earlier stages of a recoveries as opposed to the mid-late cycle expansion phase occurring in the US and Europe. Just over a year ago, Russia and Brazil were both in recession, for example.
While broad diversification is always important, investors can gain a tactical advantage by understanding the business cycle and knowing how to play. In words of Mark Twain, “History does not always repeat itself, but it often rhymes.”
• Bryan Earle Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 292-5000 for further information
• This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority