Paul Craig considers where we are in the economic cycle, and offers his view on markets in 2020.
Pundits have been saying that we’re in the “late cycle” for five years or more but markets have raced away, continuing the bull market that has been taking place for the best part of a decade.
Where we are in the current cycle rather depends on who you ask. However, amid conflicting information about the state of financial markets, it pays to break down what it all actually means, and ultimately what investors can do about it.
Let’s start at the beginning: the classic “business cycle” has four phases – early, mid, late, and recession.To be clear, the US economy is now very much in the late stages of the business cycle, which kicked off with an especially brutal, but thankfully brief, recession that ended in June 2009.
Recognition of where we are in the cycle is reflected in the US Federal Reserve’s recent decision to cut interest rates to prolong the current cycle for as long as possible.
Ticking the boxes
There are five chief characteristics of the late cycle and all can currently be seen in the US and other developed markets.
The five key “tells” are: a) a moderation in growth; b) a tightening of credit spreads; c) company earnings under pressure; d) the policy backdrop becomes “contractionary” (look for spending cuts or tax increases); and e) company inventories generally grow while sales growth slackens.
Arguably, all these symptoms were evident at some point late in 2019, when global growth forecasts took a significant hit and investors fretted over whether Donald Trump’s trade crusade with China and the European Union might derail the train altogether.
And that’s a big part of the problem with pinpointing where we are in the cycle. Political actors such as President Trump, not to mention a whole host of other populist outpourings from France and Hong Kong to Argentina, Chile, Italy, the Middle East and our own never-ending Brexit saga, have succeeded in pushing the dial closer to the red – at least in the minds of investors.
In essence, the heightened geopolitical noise to which we’ve all become accustomed over recent years has made a good contingent of investors potentially over-react and jump from mid-cycle to recessionary expectations, missing out the stop of late cycle altogether.
Consequently, we could well see a different outcome for financial assets compared with what the naysayers of the bond market are predicting, namely one where equities outperform fixed-income assets handsomely once more with cyclical sectors taking the lead from more defensive areas of the market.
Bewitched and becalmed
The rise of swingeing tariffs on virtually all goods exchanged between the US and China, sanctions elsewhere and, of course, Brexit, has helped put business investment in the freezer. With few companies investing for growth, we’ve experienced a period of “slack water” for financial assets of all kinds.
In such conditions, in the absence of other strong signals, investors become data-sensitive and consequently give too much attention to political headline-makers or short-term data points. This behaviour is ultimately responsible for the volatile swings in company share prices and prospects.
The result is that all the political intervention we’ve seen in markets – from trade-war grandstanding to the Hong Kong freedom protests – may have succeeded in breaking the cycle, at least as we know it.
This would explain why the Fed is currently setting out its stall for the mid cycle, equity markets are exhibiting all the classic signs of the late cycle, and bonds markets are resolutely priced for recession, with even Greece issuing negatively-yielding sovereign bonds.
Like how politics has been since the financial crisis, perhaps what we are witnessing is a new normal for economic and investment thinking. The classic cycle has been disrupted by the politics of the day and may never roll quite straight again.
Paul Craig is portfolio manager at Quilter Investors.