The Coming Late-Cycle Rotation

The Coming Late-Cycle Rotation

As we move into the later stages of the global business cycle, investors should prepare for some shifts in the current market climate.

Economic Expansion

To understand where we are in the current cycle and what we may expect going forward, it's useful to look at history for clues. 

Consider the real economy, which is strong and gaining steam. The business cycle appears extended, but there is still room to run when compared to previous economic expansions. Despite being over 40 quarters into this cycle, there has been just over 10% of cumulative GDP growth. Additionally, unemployment in the US is nearing all-time lows, further supporting the economy. The recent tax cuts are also expected to provide meaningful tailwinds to the strengthening economy.

 

Rising Inflation

As we head deeper into the economic cycle, we can expect inflation to rise. The Phillips Curve, which measures the inverse relationship between unemployment and the rate of inflation, shows that inflation accelerates sharply when unemployment falls below 4%, a level which the U.S. has already broken through. But there are several other factors that hint towards a rise of inflation.  The Trump Administration’s fiscal stimulus is perhaps the most apparent of these.  Applying a fiscal stimulus when the economy is robust and labor markets are tight is likely to cause more inflation than cause real growth as there is little spare economic capacity.

A slowdown in global trade could be another key element. The escalation of global trade has been a significant factor in muting inflation in recent years. Global trade markets have created enormous pricing efficiencies. The chart below illustrates that the cost of goods which can be imported from other countries without incurring significant costs (blue line) have experienced little inflation since the 1980s. In contrast, the cost of services, which must be obtained domestically (orange line), have steadily increased. This highlights the significance of rising protectionist policies and potential trade wars. Not only will prices naturally rise as new tariffs are implemented, but global trade, which may be the most significant factor in depressing inflation, will falter.

Price Inflation: Goods versus Services

 

Source: FRED Economic Data | Federal Reserve Bank of St. Louis

Rising Rates

As the economy expands, interest rates are expected to rise, putting upward pressure on long-term rates. Supporting this view, the Goldman Sachs US Financials Conditions Index -- which tracks changes in interest rates, credit spreads, equity prices, USD value and other macro variables -- hit a record low earlier this year.  The easy financial conditions this represents should allow the Federal Reserve to be more comfortable moving faster on their path towards policy normalization and higher rates.

Financial Conditions Index / Fed Funds Rate

 

Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

When examining the performance of asset classes during periods of rising rates, there are notable winners and losers. In general, fixed income positions suffer, as rising rates negatively impacts bond prices. Equities, on the other hand, digest higher yields quite well, but with a pick-up in volatility and sector dispersion. Additionally, the credit and equity risk premiums also rise. Volatility should be expected to amplify as G3 quantitative easing (“QE”) shifts to quantitative tightening, which is expected to occur in the back half of 2018 and into 2019.

Within the equity market, cyclicals have typically outperformed defensives in such periods; value has tended to outperform growth; small caps have tended to outperform large caps; and international equities such as the TOPIX, MSCI World, Stoxx and MSCI Emerging Markets have typically outperformed US equity markets. When looking outside of traditional asset classes, commodities such as copper and oil have historically performed well.

A Weakening US Dollar

It is a common misconception that as interest rates rise, the US dollar strengthens. History has shown that in past Fed hiking cycles, the US dollar typically declines. We believe the value of the US dollar will be driven by twin deficits over the medium-to-long term 

  • Fiscal deficit – Expected to exceed $1 trillion within 2 years.  If all current polices are extended, which we do not think will happen, it will hit $2 trillion by 2027.  The tax bill along with a potential infrastructure expenditure are occurring late in the cycle  
  • Trade deficit – Despite the rhetoric surrounding trade, the US will remain a net importer based on its stage of development and wage levels relative to the rest of the world.  As GDP increases, the trade deficit is expected to increase.
     

A Weak U.S. Dollar During Fed Tightening Cycles is the Norm

Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

By 2020, the IMF estimates Europe will have a 4% twin surplus while the US will have a -8% twin deficit. This would likely cause a capital redistribution from the US to Europe. Under the weight of rising rates and increasing twin deficits, the US dollar will face mounting pressure as the cycle continues.

It should be noted that over the short-term, the US dollar may strengthen as it is currently a carry currency given the US has higher rates than other developed economies, and it can be used as a flight to safety given the recent spikes of volatility in Europe and Emerging Markets.

Increased M&A Activity

M&A activity historically picks up during the later parts of the credit cycle. Corporates are healthy with a tremendous amount of free cash on their balance sheets. These companies look towards strategic initiatives to achieve rising growth targets and to combat increasing global competition. Executives are compelled to buy growth.  The levers in the form of expanding valuation multiples, cost cutting, and growing organically are generally unavailable, thus executives are forced to turn to inorganic growth (i.e. M&A). Further supporting the M&A environment has been tax reform and decreasing regulation under the Trump administration.

Merger and Acquisition Activity (in billions)

Source: Citi

As we move into the later stages of the global business cycle, we anticipate that the following broad themes may begin to emerge or remain in place:

  • Economic expansion
  • A rise of inflation
  • Higher interest rates / pressure on Fixed Income
  • More volatility in equity markets
  • International equity outperformance vs. US
  • Higher commodity prices
  • Pressure on the US dollar
  • Increased strategic initiatives

Domestically, we anticipate the following relative conditions:

  • Value to outperform Growth
  • Cyclicals to outperform Defensives
  • Small-caps to outperform Large-caps
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