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The economic cycle – signs of age?

When it comes to the economy, outside factors are the most common catalysts for change. Here, we look at some of the things influencing the current cycle in relation to the investment landscape.

Economic cycles don’t die of old age. They usually get snuffed out either by external events, such as oil price shocks, or by central banks stepping on the brakes to deal with internal economic excesses.

With these excesses tending to build over time, it is not surprising that this near decade-old US economic cycle is starting to wrinkle a little in places. Meanwhile, higher US interest rates will help to reveal more such signs around the world in the months ahead. Here, we explore some of the things we are keeping an eye on in the context of an economy that still looks likely to reward investment portfolios tilted towards stocks.

Bad debts

One of the deliberate effects of this decade of extreme central banking, characterised by low or even negative interest rates and wave after wave of quantitative easing, has been the so-called ‘search for yield’. Investors with a specific yield in mind have spent much of this cycle holding their nose to achieve it. This necessarily less scrupulous attitude to risk has provided cover for some of the less creditworthy corners of the economy to access finance at unsustainably low interest rates.

Meanwhile, some credit instruments we might have thought would be hiding in shame for a good deal longer have returned. As of yet, the aggregate exposures do not look alarming. However, such wrinkles are always easier to see under the harsher light of higher interest rates, which we expect to see more of from the US in the year ahead.

Wages and inflation

Higher wages and wider inflationary pressures tend to be lagging indicators of economic strength. Unsurprisingly, we find that, in the US, both of these indicators are now on a more durable uptrend. There is no cause for alarm yet – the inflation genie remains in the bottle as far as we can see. However, there are growing signs that the labour market is running out of supply.

US workers getting more comfortable quitting generally speaks of a confidence in their ability to get higher-paid work elsewhere. Even though the translation of wages into inflation tends to be a slow and uneven process, this and other indicators show that the US economy is beginning to run out of spare capacity. Other parts of the world have more, but it is the US that still matters the most for the global business cycle.

Reversing austerity

Economic orthodoxy has been overturned in many areas during this cycle. However, the harsh austerity many governments inflicted on their electorates when the underlying global economy was weak is perhaps one of the more prominent examples. Its reversal, just as the economy seems to be finding its feet again, similarly flies against traditional economic practice. The lavish US government splurge of this year is landing on an economy that is already using much of its resources.

Over the short term, growth will rise. But the risk of onerous inflationary pressure increases with it. Populists around the world are agitating for more of the same – some with justification, some less so. With global growth picking up, the case for fiscal stimulus is getting weaker. And the bond markets are likely to penalise irresponsible budgets, as we have recently seen in Italy.

However, if the US stimulus translates into substantially higher inflation, there will be a more aggressive cycle of rising interest rates, with important implications for all corners of the world. Even though this is not our base case, it would make the next US and global recession more visible on the horizon.

Investment conclusion

As we’ve pointed out before, the last phase of the economic cycle tends to be a very important period to be invested through. Outsized gains, and eventually losses, are usually registered.

The first half of the year has been characterised by the global economy pausing for breath after that incredible acceleration from the middle of 2016. We see this breather as passing and the economy providing a more visible lead for capital markets in coming months. This should see stocks more firmly outperform a bond market that will have increasingly resolute central bankers and a bit more inflation to grapple with.

Higher interest rates will help reveal some of the overstretched borrowers and careless lenders. But, provided any rate rises happen gradually, this may help to discourage other future accidents waiting to happen. It will also help to keep a lid on those inflationary pressures that could become so disruptive. For now, the economic cycle still looks sufficiently vital to support our continuing tilt towards stocks at the expense of the high quality areas of the bond market in particular. You are only as old as you feel, after all.

Key takeaways

  • The global economy is likely to continue to reward investment portfolios tilted towards stocks
  • Higher wages and wider inflationary pressures in the US appear to be on a more durable uptrend
  • Economic indicators point to a US economy that is beginning to run out of spare capacity
  • We expect to see higher interest rates from the US in the year ahead.

“The last phase of the economic cycle tends to be a very important period to be invested through. Outsized gains, and eventually losses, are usually registered.”
Pete Downey, Barclays, Isle of Man.

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