We are in the later stages of the second-longest bull market in history and, as time goes on, the question is not if the bull market will end but when. However, this might still be some time away. The International Monetary Fund recently maintained its positive outlook on global economic growth, forecast to be 3.9 per cent in 2018, the best annual growth rate since 2011. According to independent investment research house BCA Research, the odds of a recession in the United States are close to zero on a nine-to-12-month horizon.
We expect that if the US Federal Reserve maintains its gradual raising of interest rates, there is a high probability of a US recession in 2020, with the potential for repercussions in the Australian equity market. As we continue towards what could be the longest bull market in history, the US economy (and, in turn, the Australian economy) will eventually approach its late-cycle phase. A late-cycle phase is typically defined by a slowdown in growth, low levels of unemployment across major economies, rising inflation, high cash rates, low appetite for risk and a flattening yield curve. By the time the US economy enters a late cycle, earnings growth will be slowing and profit margins shrinking, which due to tax cuts hasn’t yet happened. This period before a recession where the economy contracts and consumer expectations are at their worst presents many opportunities for investors.
What to watch
A key leading indicator to watch in identifying phases of the business cycle has been the ISM Manufacturing Index. This index is based on surveys of more than 300 manufacturing firms and is one of the first investor news announcements released each month in the US. Historically, the ISM has been a lead barometer of recessions and S&P 500 troughs, with previous peaks in the S&P 500 following a peak in the ISM.
While the most recent ISM peak was in March 2018, the S&P 500 index has not yet seen cyclical highs, providing an opportunity for investors to position their portfolios appropriately before the end of the cycle. With a low number of observations and variances impacting the averages of past iterations, these can only serve as a rough guide. The ramifications for Australia during global slowdowns and a US recession can be rather direct. Performance across asset categories typically rotate in line with different phases of each economic cycle, with investment opportunities in late cycles differing from those in the cycle’s early phases.
The key to managing and investing during a late cycle is identifying sectors that perform well relative to the rest of the market. In equity markets, sectors such as technology and industrials perform better in the early and mid-cycle phase when economic growth is at its strongest. When the market falls into a recession, these sectors have tended to underperform. Defensive sectors such as consumer staples and healthcare have historically been better performers during late-cycle periods when economic growth is peaking to declining.
As we head towards later in the cycle, the healthcare sector is already starting to see the benefits. CSL Limited (ASX: CSL) has become one of the top four largest Australian listed companies by market capitalisation and we expect it will continue to cement its global position and profitable niche. With consumer staples another sector winner in the late-cycle phase, strong performers including Woolworths (ASX: WOW) and Wesfarmers (ASX: WES) should continue to achieve above-average returns.
For the 2018 financial year the S&P/ASX 200 Accumulation Index finished strongly, closing up 13.0 per cent and we expect the Australian market will rise in FY2019, albeit marginally. With steady global growth and modest inflation, market conditions continue to be supportive of equities. Risks for global markets include central banks taking an overly hawkish stance on interest rates and the potential for a surprise in inflation levels. Although we expect that a recession is not in the immediate future, now is the time to position your portfolio in advance of a late-cycle phase.
Matthew Haupt is portfolio manager for WAM Leaders and Century Australia.
First published in the Australian Financial Review, July 24, 2018