Where has the business cycle gone?
A couple of weeks away on the beach does wonders for the investment psyche and helps put all the noise into perspective. However, what is somewhat concerning is that there seems to be even more bears around than before embarking, willing a correction to occur. But corrections don’t just happen; there has to be a sufficiently scary catalyst, causing investors to panic and prefer cash, earning negative real returns in the meantime.
As we all wait for this correction event, with many on black swan watch having already moved to the side-lines, perhaps we should be thinking slightly differently. In this instantaneous communication age of social media, the investment community has more analysis and information than ever before, even on the beach, to make quick decisions. As media delivery has exploded, so has the creation of every doomsday scenario and its communication, defaulting to the negative, as media stories always do. This means that investors could become complacent, discounting negative scenarios as irrelevant, even when there really is something to be concerned about. There is precedent for this at both the market peaks of 2000 and 2007, when the initial sell-off in TMT and sub-prime credit was ignored for a few months and interpreted by some as buying opportunities. Even Central Bankers, in the case of the latter, didn’t see what was coming. The lesson here is to always be vigilant and to never assume the consensus has an advantage in forming that view.
Measuring the business cycle
The one thing that is puzzling is the absence of the business cycle as we have historically known it. It is defined as the period between when an economy begins to grow in real terms, as demonstrated by increases in indicators like employment, industrial production, sales and personal incomes, and the opposite when the economy is contracting and those same measures are decreasing. According to the National Bureau of Economic Research in the US, there have been 11 business cycles between 1945 and 2009, with the average cycle lasting just under 6 years. Knowing where we are in the business cycle is crucial for successful positioning of portfolios and, most importantly, knowing where the market thinks we are in relation to that is where opportunities lie if there is a disconnect. Many at the moment think we have run off the cliff but are yet to experience gravity. Others perceive there to be no cliff anywhere on the horizon, whilst some can see a cliff but are not sure how long it will take to get there!
If we have run off the cliff, then defensive positioning in stable cash-flows and dividend yields is the order of the day. Otherwise, stick with cyclicals, such as commodities and technology, as economic growth continues. The only trouble is both parts of the equity markets look expensive. The former are bond proxies; with interest rates so low, these are vulnerable to rate rises. The latter have driven the US equity market, in particular, to new highs and sit on eye-watering valuations. This is hardly an appealing choice.
Coming back to the business cycle, the current version is believed to have started in June 2009. This means that we are now over 8 years into this cycle, with no apparent evidence to suggest there is a cliff approaching. However, if both defensive and cyclical areas of the equity market look expensive, as well as bonds, the investor has limited choice of where to put the lion share of his asset allocation, outside of the usual illiquid alternatives of property, infrastructure, hedge funds and esoterics. However, the first two of these also look expensive, with discounts to net asset value at lows or premia, suggesting little value. This leaves hedge funds, other market neutral approaches and esoterics, but these are not common for the average investor, and usually comprise no more than 25% allocation at most.
So, what to do? Stay on the overvalued rollercoaster, hoping it will stop at a convenient time to get off? Or get off now and sit tight waiting for the inevitable, because it will come at some point. Trouble is, you may have to wait for quite a while and earn negative real returns as you do. For me, I would focus on those areas that still give a reasonable real return but are less likely to fall, should a cliff suddenly appear. But perhaps we need to think in unconventional ways. Perhaps there is no cliff and the business cycle has been interrupted by all the quantitative easing. After all, outside of investors, very few feel better off over the last 8 years. Supposedly there has been economic growth and a recovery, but to many, it feels like we are in a recession, with austerity still restraining confidence and combating any real feeling of increased disposable income. Many consumers have rebased their monthly debt payments back to where they were before the credit crunch; on aggregate they are lower, which feels comfortable. However, with interest rates so low, the actual amount of debt is considerably higher, which means the effect of just a 1% increase in base rates could create a recession. A point not lost on Central Banks, hence their reticence to raise rates.
So perhaps with the business cycle as we know it – excessive confidence, overinvestment, boom followed by inflation – interest rate rises and bust will not occur. Perhaps we will see a prolonged sideways move in investment markets as they wait for the fundamentals to grind higher, assuming they do. Early releases of GDP data for Q2 have all undershot, not alarmingly, but there is clearly a softening even though the markets are unperturbed. The UK residential property market has ground to a halt for many reasons related to Brexit. Values will need to fall a long way before consumers become frightened; as there has been so much wealth created over the last 8 years, the overvaluation buffer is huge and there is still a shortage of supply.
Even though it looks increasingly likely that Trump will fail to deliver much of his reflation agenda, the US equity market is trending sideways and underperforming globally. There is some justifiable scaremongering going on about UK dividend cover, especially as earnings in some of the big FTSE payers have been boosted by Sterling weakness. When and if this reverses when we eventually secure a positive out of the Brexit negotiations, income defensives could be vulnerable.
So, if there is no cliff and the business cycle as we have historically known it is dead for now, perhaps we will just see low returns with low volatility, with everyone looking at one another, nervously talking down the market. I suppose there is a possibility that a sink hole slowly opens up beneath our feet, as dividends and earnings fail to live up to expectations. The key question is when and how deep?
Guy Stephens, technical investment director at Rowan Dartington