Later-cycle markets demand caution, not a disengagement from risk

This investment cycle is not in its infancy. No one is arguing that. What’s more contentious is whether the cycle is on its last legs – “late cycle” as some would argue – or actually maturing with still some way to run, as we believe.

For those prepared to “stay engaged” with risk markets, we expect positive returns are likely to persist in the near term – albeit decidedly less buoyant and less easy to find than last year.

Judging the cycle to be at its end – as some have done (and mistakenly did this year) – arguably has to be more complicated than just observing stretched asset valuations or approaching an historical precedent for “normal” cycles. Given the depths of the global financial crisis a decade ago, the pace of technological advancement and the current plethora of geo-political tensions, this is anything but a normal cycle.

The US Fed is still more than 0.5 per cent below its estimate of a “normal” interest rate. Greg Newington

Cycles typically end because something goes wrong. Most often that comes in the form of restrictive policy, policy error or financial crisis. US President Donald Trump’s fiscal largesse may well be the policy error that has sown the seeds of the next recession, potentially in 2020.

But for now, there are few tell-tale signs that the cycle is about to confront a hard roadblock, such as rapidly rising inflation, a financial crisis or a sharp slowing in global growth.

For sure, wage growth is belatedly rising across the US, Europe and Japan, but remains well below that in prior cycles. Inflation has also risen toward, but is yet to move above, central banks’ key targets in any major jurisdiction. Last week’s surprisingly tame US inflation data once again questions just how quickly rising wages will show up in higher inflation in a world of rising new investment and technological change. Further, trends in business surveys have recovered from their early-year weakness to be consistent with well-above-average global growth this year and next.

As Northern Trust, one of the world’s largest custodians, recently highlighted, the US cycle has “plenty of room to grow” based on previous expansions, with growth rising 41 per cent over the past decade, compared with around 75 per cent in both the 1980s and 2000s expansions. The US Fed is still more than 0.5 per cent below its estimate of a “normal” interest rate, and new chair Jerome Powell at the August central bank talkfest in Jackson Hole noted that “there does not seem to be an elevated risk of overheating”. In Europe, interest rates look on course to rise from negative levels to just “zero” by the end of 2019.

Caution needed

And yet maturing cycles still embody tension. Growth remains strong, though not accelerating. And after a decade of tremendous gain in risk assets, nothing is arguably “cheap”. Balancing the fear of an unexpected correction, UBS recently showed that since 1928, average returns in the final year of an equity bull market have been 22 per cent. This cycle also has the added challenge of persistent (and unforecastable) trade wars and other geopolitical risks that could weigh heavily on risk appetite.

So is there value staying engaged in late cycle markets?

While closer to its end than its beginning, the evidence suggests that the economic cycle still has some way to run. Adopting highly defensive portfolios too prematurely can come with significant cost to returns. Similarly, attempting to time markets by stepping away from the discipline of a diversified portfolio (with in-built defensive assets for protection) has invariably delivered inferior returns for investors.

But later-cycle investing still demands caution. It involves understanding that returns are likely to be more moderate and more volatile than earlier in the cycle. It also involves keeping a weather eye on the macroeconomic signals that the growth cycle is truly weakening.

Caution in the later cycle also means not being overweight risk yet remaining engaged with it. Allocations to risk assets should be neutral (or normal), not aggressively overweight and focused on regions and sectors where growth is strong or valuations more compelling.

Protecting capital through maturing cycles is also key. Investors should ensure ample cash and liquidity and be seeking out high-quality uncorrelated “alternative” assets (such as hedge funds) that can protect capital when forecasts are wrong.

When the economic cycle turns, the market’s ability to look through many of the geopolitical risks that now confront us will undoubtedly be challenged. This should also be the point that investors gather comfort from a diversified portfolio and can put liquidity to work accumulating high-quality assets at more attractive prices.

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