Outlook 2020 | A tale of 3 cycles

Investors are usually encouraged to think long-term and look through temporary ups and downs. At the same time, we keep hearing about “the cycle” and how advanced it is. We know from experience how painful it can be when bull markets turn into bear markets, and our human instincts are hard-wired to avoid danger. But what do we mean when we talk about the cycle, and how useful is it for investors?

Economists who build models to predict the next recession can only study previous recessions, and they tend to focus on the United States.

Fortunately, given their global impact, US recessions do not happen very often, with only seven occurring in the last 50 years. This means that there is little evidence for forecasters to work with. And while we don’t want to fall into the trap of assuming that “this time is different”, there are certain features of the current environment that are different from previous periods.

Another dangerous trap for investment managers is to assume that everything we need to know can be captured in a model, however sophisticated it may be.

Figure 1: The Credit Cycle - Household balance sheets have improved.

We prefer to think along 3 different lines: the business cycle, the credit cycle, the market cycle.

• The business cycle

When people talk about the cycle, they usually mean the business cycle. In other words, how is the economy growing? An obvious sign of a healthy economy is the labour market - jobs growth and wages are key indicators. Inflation is another important measure because when prices rise too quickly, central banks raise interest rates which often causes recessions. In developed economies, consumer spending is the largest and most stable component of growth. Manufacturing and business investment are much smaller but more volatile. In most recessions, it is these sectors that fall the most. So recession forecasters look at hard data, such as industrial production and transportation, and soft data such as business surveys, to gauge the strength of growth.

• The credit cycle

A healthy financial system is vital to a growing economy, as money flows to borrowers who need it, providing returns to savers. But when borrowed money is used to fund excessive consumption or unproductive investments, and the debt can no longer be supported, the virtuous circle breaks.
As we know from 2008, this can be catastrophic for the entire economy, including both borrowers and lenders. Credit crises are much rarer than business recessions, but when they do happen, the fall tends to be deeper and the recovery longer and slower. To understand where we are in the credit cycle, we look at the level and growth of private debt and the size and quality of bank balance sheets.

• The market cycle

Finally, and most importantly for investors, we have the markets themselves. To measure whether they’re running hot or cold, we closely look at valuations but also at flows. Markets typically don’t collapse under the weight of their own prices, unless these are at extreme levels. Instead, most bear markets happen around recessions when company profits fall. Although if enough people fear the business cycle may be about to turn, the market cycle can stumble from a loss of confidence. While valuations don’t predict turns in the cycle, they are still important because they tell us the prospective size of the return opportunity. The higher the price, the less we are likely to profit from growth.

Now that we have described the three different cycles, we look next at the major economies in the world to see where they stand in their own business, credit, and market cycles - enabling us to assess the current situation.

Figure 2: A subjective assessment of the 3 cycles as at Q4 2019

Source: Davy

Now that we have described the three different cycles, we look next at the major economies in the world to see where they stand in their own business, credit, and market cycles - enabling us to assess the current situation.

United States

US economic data is a mixed bag. The job market is very strong, consumers keep spending, and yet inflation is still tame. However, manufacturing has contracted, and companies are reluctant to invest amid the uncertainties of the trade war and the upcoming election. Our outlook for 2020 is that this business cycle will endure. Indeed, manufacturing may be recovering already. A trade truce with China would be a boost, but even without one, we do not see an imminent recession in the US.

Looking at the credit cycle, US households have de-levered significantly since 2008, reducing debt levels by almost a quarter. Banks have also built up stronger balance sheets. Where US debt has seen an increase is in the corporate and governmental sectors.

While we take comfort from the business and credit cycles, the US market cycle is a cause for concern. Valuations have moved ahead of economic prospects. While this is not enough reason to sell US equities, the rewards to continued growth should be lower. We also note that with extended valuations and nervous owners, the market is more vulnerable to panicky sell-offs, as we witnessed twice in 2018.

Europe

The European economy is several years behind the US, with the added complications of the Eurozone crisis and Brexit. Unemployment reduced significantly and core inflation is well below target. While consumers are spending more again, Europe’s higher reliance on manufacturing and trade means that overall growth, especially in Germany, remains weak.

On a positive note, private debt levels have receded across Europe, particularly in countries like Spain and Ireland which saw massive de-leveraging. Banks have also improved their balance sheets, even as they struggle to grow earnings with negative
interest rates.

As in the US, the market cycle has moved well ahead of the economy. Apart from dividends, almost all of the returns from European stocks since the financial crisis have come from an increase in valuation, and not from earnings growth. We will discuss this in more detail in our article focused on global equities.

China

Measuring cycles in China is even more difficult because good data is not available, and because of the heavy hand of the government. The trade war has lowered 2019 growth to roughly 6%, its lowest level in almost 30 years. We believe the government will act to prevent a contraction in the business cycle. However, this may lead to other problems. For many years, the Chinese government has maintained rapid economic growth by expanding private debt at an even faster pace. We can’t tell if or when this becomes a credit crisis, but it makes us nervous about the financial system in China.

The local Chinese stock market is still well below its 2015 level, and many commentators point to China as a tactical play for 2020. While the overall market may be at fair valuation levels, the parts that we would prefer to own, i.e. the consumer and service sectors, are more expensive.