The cycle grew old before it got rich

Tracey McNaughton

Escala Partners

The US equity bull market has just turned the ripe old age of ten. In market years, this is considered old-age. In fact, this bull market is the oldest on record using data going all the way back to 1947. The economic cycle is similarly old. Such stamina is good news for investors.

The cycle got old before it got rich, however, evidenced by the fact that this is the weakest economic expansion since WWII. Not surprisingly we now find ourselves back on assisted living from central banks. What does this mean for investors?

Old before it got rich

This US economic cycle and bull market began in the wake of the Global Financial Crisis (GFC) in 2009. The policy tool of choice post-GFC was monetary policy. The amount of liquidity pumped into the financial system by the major central banks around the world amounted to $16 trillion. This kind of stimulus was unprecedented. And yet, it generated the weakest recovery in the post WWII era.

There are many reasons for this. Among them is the rise in income and wealth inequality and the ageing of the population. Together, these two large macro trends had the effect of putting downward pressure on aggregate demand and encouraged corporates to distribute free cash flow as dividends and share buybacks rather than re-invest back into the business. Goldman Sachs, for example, estimates Apple spent $74 billion on share buybacks in 2018, 2.5 times more than it spent on capex and R&D.

The resulting decline in productivity growth has left potential growth rates, the growth rate most tied to where neutral monetary policy is, lower. The chart below shows the potential growth rate in the US has fallen from an average of 3.5% pre-GFC to 1.5% post.

Why is this important?

A lower potential growth rate means lower interest rates which means the operation of monetary policy is hampered. Official interest rates are at a record low in Australia and yet we are talking about cutting rates further. In Europe, as in Japan, where ageing demographics are more apparent, the situation is stark. Nineteen countries in Europe now have negative interest rates! The official interest rate in Japan has been under one percent since 1995. 

It also means the neutral policy rate – the rate that neither stimulates nor contracts – is lower. Neutral is a nebulous concept. It can only be indirectly observed by watching how the economic data respond to the current interest rate setting. Judging by the apparent slowing in the economic data in the US, neutral seems to be at or even a little lower than where we are now. Where we are now is just 2.5%!

For the first time in US history, a paltry 2.5% interest rate looks restrictive.

Back on assisted living

The market now finds itself older and back on assisted living from the central bank. It is becoming increasingly apparent that we are about to re-enter a world were risk premiums are artificially suppressed by central bank sponsored liquidity. This is reflected in the growing disconnect between fundamentals and sentiment drivers of the market. Equity investors are pricing in the central bank being the cushion that will save them in a correction.

As was the case the last time we were on assisted living (2009-13), fundamentals will take a back seat and technical, momentum and sentiment factors will become more important. Asset allocators need to consider more than just the earnings and macroeconomic drivers of the market. Indicators like fund manager positioning, fear and volatility indexes, fund flows, and seasonality also need to be considered. Ultimately the market does reflect the fundamentals but in an environment of unconventional monetary policy, these fundamentals can diverge from market pricing for very long periods of time. An extreme example to be sure but in Japan, where unconventional monetary policy has been operating the longest, bonds have been expensive for over two decades!

When central banks so heavily affect the dynamics of price discovery strange things happen. 

Strange things indeed. Volatility is suppressed which ultimately leads to crowding of trades. Correlations between asset classes rise as market participants move to the beat of the same drum – central bank positioning.

Much like a coiled spring these positions can unwind quickly and violently. Between the original “taper tantrum” in May 2013 and December 2016, the market experienced on average, two tantrums per year whereby compressed premiums sprung to life leaving the central bank to step in to stabilise sentiment.

How does an investor position in this environment?

Specifically, this environment favours growth over value. Growth stocks are typically associated with higher multiples on the expectation that their revenue and profit growth will be faster than the market average. If inflation is low, this growth will be more valuable in today’s dollars.

It pays to be at least neutral on your fixed income allocation. Bonds will likely trade in a fairly tight range leaving large shorts to go unrewarded in a lower for a lot longer environment.

In the alternatives space, traditional long/short macro hedge funds will struggle as they did during the tantrum years. This is in part because of the increase in asset class correlations associated with central banks suppressing price discovery. The value of a hedge fund is in its uncorrelated returns. When markets are momentum driven that value tends to disappear.

With age comes wisdom but it also brings risks such as more frequent stumbles. Investors participating in this ageing bull market will be wise to take it easy; don’t stretch for return; have a well-padded diversification cushion in place. And remember to keep your liquids up.

Tracey McNaughton
Tracey McNaughton
Chief Investment Officer
Escala Partners

Tracey was appointed Chief Investment Officer at Escala Partners in November 2019. In this role she has responsibility for strategic and tactical asset allocation and manager selection across all multi-asset funds, and is Chair of the Escala...

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