From the blog: What goes up must come down. Bull runs cannot last forever and after a prolonged period of strong equity returns – against the background of an economic recovery that has lasted eight years – investors are wondering whether the end of the business cycle is within sight.
However, many argue that fears of a looming recession have been overplayed and trustees should not get cold feet on equities.
Pessimists argue the duration of business cycles is the main cause for concern.
However, many argue that fears of a looming recession have been overplayed and trustees should not get cold feet on equities.
Stable default rates in investment grade and high-yield markets suggest there is still life in the current cycle
Pessimists argue the duration of business cycles is the main cause for concern. Eight years is fairly long, but that doesn’t justify the label ‘late cycle’ to describe the global economy currently.
Growth has been more modest than in previous cycles, and given modest pickup in global inflation during the past year, this suggests there’s still slack in product and labour markets.
A late-cycle environment is often characterised by a lack of spare capacity, which causes central banks to tighten monetary policy to stave off inflation. Aside from the US Federal Reserve’s modest tightening path, within the developed world monetary policy remains accommodative.
Elsewhere, you would expect a higher degree of speculative excess at the end of a cycle. However, investors have consistently run high cash balances. Given the rise of macro regulation, there are few signs of excessive leverage in the global financial system.
Another sign of investor complacency is excessively low risk premia. Analysis suggests risk premia more than compensates investors for holding equities rather than bonds, all the more so given this year’s decline in bond yields and the strong pickup in corporate earnings during the past six months.
If entering the tail end of the business cycle, what are the warning signs? As the US has driven global growth, you would expect it to falter first. Current quarter growth in excess of 3 per cent seems likely, with full year out-turn around 2.25 per cent, even without tax reform or fiscal stimulus. The Bank of Japan and European Central Bank are maintaining asset purchases, and while the Bank of England has finished its bond buying programme, rate hikes appear to be some way off, given the weakness of recent macro data.
There are deteriorating fundamentals in the corporate bond market in a late-cycle phase, reflecting increased leverage.
However, stable default rates in investment grade and high-yield markets, and pickup in business investment from internally generated cash suggest there is still life in the current cycle.
Balance of probability indicates there is further to run in this cycle than many investors believe. But even if this is wrong, equities typically post strong gains in a late cyclical scenario as companies focus on equity-friendly behaviour at the expense of bond holders.
Bob Campion is senior portfolio manager at Charles Stanley Asset Management
