Late cycle investment ideas as expansion approaches record length
Barring any unforeseen derailing, the current economic expansion in the US is likely to become the longest on record in July next year, based on figures dating back to the 1850s.
While most commentators have yet to call time on the current US and global growth cycle, there is growing consensus the expansionary period – which has been characterised by unconventional monetary easing – is reaching its latter stages. If the cycle is nearing its end, where should investors be looking to allocate capital? See below for some late cycle investment ideas:
Real assets – Vince Childers, manager of the Cohen & Steers Diversified Real Assets Fund
After one of the slowest expansions in history, the global economy is heating up and long dormant inflation pressures are beginning to build. This cyclical shift – combined with unusual late-cycle tax cuts in the US, rising protectionism and the unprecedented unwinding of quantitative easing – is thrusting investors into uncharted territory.
As we enter the latter stages of the business cycle, we believe investors should consider increasing allocations to reflation-oriented asset classes – including infrastructure, REITs and other real estate securities, as well as commodities. Real assets are commonly known for their inflation-hedging characteristics. However, real asset performance is not so much related to the absolute level of inflation, but whether inflation exceeds expectations—the ‘inflation-surprise’ factor. Historically, real assets have tended to benefit from periods of unexpected inflation, contrasting with below-average returns for stocks and bonds.
Years of successive downward inflation revisions since the financial crisis have worked against real assets, contributing to their significant underperformance recently—particularly in commodities. However, we believe increased inflation risk and improving fundamentals have created a more favourable backdrop for real assets. With many listed real asset categories currently trading significantly below their highs, we see this is as an attractive value opportunity for establishing a blended real assets allocation.
Oil – Richard Robinson, manager of the Ashburton Global Energy Fund
Our thesis of continued oil price strength over the medium term remains intact. The collapse in the approval of new oil projects since 2014 has meant we are rapidly heading towards a new reality of undersupply and low storage levels – far from the environment of a market drowning in oil that was evident just a few years ago.
Last year, the world discovered the least amount of oil since the 1930s, while 2016 and 2017 were not much better – uncovering the lowest levels since the 1940s. At the same time, the market continues to face heightened risk to supply as a result of the lack of spend and increasing political volatility in oil-producing nations, such as Venezuela, Angola and Iran, at a time when spare capacity has shrunk to levels only seen once in the last 20 years on a ‘days of forward cover’ basis.
With the positive outlook for the oil price unfolding over the next few years, integrated oil companies are beginning to show significant cash balances and industry reserve replacement ratios appear increasingly challenged post 2020, a problem that needs addressing now. As a result, we believe capex in the offshore space is poised to move higher, driven by a fundamentally well supported, stronger oil price over the foreseeable future.
Specialist health care – Oliver Harris, managing partner of Montreux Capital Management
We are experiencing one of the longest economic expansions in history and it is only natural investors are becoming increasingly concerned about identifying durable investment destinations over the medium term.
Specialist healthcare is an especially resilient asset class because of its dependable cash flows and essential service provision. Its cash flows stem from the NHS and from insurance pay outs where claims have already been agreed – which near-guarantees revenues. Cash flows and revenues should keep pace with inflation as contracts are renewed on a rolling basis.
These assets do not face the same challenges of overvaluation as bonds and equities, which have undoubtedly been bid-up during the era of QE. Instead, valuations in specialist healthcare have largely been driven by rising demand from a growing population and the undersupply of specialist care facilities in the UK, which provides a stable foundation for investment.
The specialist care market in the UK is highly fragmented with the top 10 providers owning less than 15% of a sector dominated by smaller businesses – which are typically family owned and operated. The sector offers lucrative opportunities for a large national provider able to streamline operations, drive business efficiencies and, ultimately, improve care outcomes. Smaller specialist care businesses can be valued at as little as 5x EBITDA, while larger operators are valued in excess of 10x – offering significant arbitrage in the consolidation process.
Diversified fixed income – Brad Tank, CIO and global head of fixed income at Neuberger Berman
There is one question on just about every investor’s lips right now: ‘How much longer can this credit cycle go on?’ Maybe this is the wrong question. Instead of when the cycle will end, perhaps we should concern ourselves with what the cycle will look like when it does end, and whether some markets are priced as though it will never end.
Which markets are asking you to be optimistic in perpetuity? For us, CCC-rated US high yield would be on this list. Even parts of investment grade call for rigorous credit discipline. The BBB-rated sector has ballooned, and while the rating probably overstates the risk in many financials and utilities, some businesses in the traditionally defensive sectors are at risk of a downgrade after stretching finances for acquisitions.
In some cycles, it has paid to hang on to the ‘high-beta’ assets to benefit from the full share of the remaining upside. This time around, the potential upside from these overheated markets appears vanishingly small. In other words, no matter when you think the cycle will end, it is not too early for credit investors to consider building a bias to quality and tightening up issue-selection criteria. If you have a multi-sector fixed income portfolio, we caution against giving in to the temptation of going all-in for the emerging markets rebound or a high yield ‘melt-up’, and remain in favour of being well-diversified across all markets and regions.