We are mid cycle, not late cycle

Do you remember in 2018 when everyone was selling everything, and the so-called smart money was convinced the US and global economies were heading into recession? It was a wall of worry: there was the trade war, Brexit, North Korea, the impact of the Fed’s interest rate hikes, and frankly anything to do with Donald Trump.

Equities were down 20 per cent at one stage. Aussie house prices were suffering their largest correction in over 30 years. Credit spreads were blowing sharply wider. Australia and the major banks’ ratings were on watch for a downgrade. And institutional investors were dumping anything that was perceived to carry risk. Even the great Jim Simons of Renaissance Technologies was personally overriding his quant models’ signals.

Well it turns out everyone was wrong. Precisely the right time to be buying everything was when the market was throwing the baby out with the bathwater—at that point when we were hitting peak fear. Click here to read the full column or AFR subs can click here. Excerpt enclosed:

The trade war is over (sort of). In May we put a 50 per cent probability on a meaningless deal to sate markets or no deal at all. We got the former. Brexit looks like it will be resolved in a benign fashion. The US and global economies have kept expanding with unemployment rates in the US, UK, Canada and New Zealand below or near their all-time lows. Australia’s sovereign and major bank ratings were upgraded, partly as a function of the federal budget returning to surplus and the housing market recovering. And two of the raciest asset-classes, leveraged equites and residential real estate, have soared to new highs.

After falling 3.5 per cent on a calendar year basis in 2018, Australian shares plus dividends are up a stunning 26.5 per cent (see chart). Global equities have done even better, returning almost 30 per cent before fees. If your active fund manager is not approximating these returns, you would have been better off in a passive exchange traded fund (ETF) that tracked the market.

After we forecast a sharp rebound in Aussie house prices in April, national home values troughed in early July and have since jumped 6.8 per cent. That is in line with our April projection for capital gains of up to 10 per cent over the 12 months to June.

Since many presume bonds are negatively correlated with equities (the truth is that this correlation has been positive over the long-run), one might suppose that fixed-income fared poorly. But in practice it has yielded equity-like pay-offs notwithstanding the RBA slashing its cash rate three times this year with the average cash rate over 2019 slumping to just 1.1 per cent.

Australian fixed-rate bonds have appreciated 8.4 per cent in total return terms as the yield on the AusBond Composite Bond Index declined to 1.0 per cent in October, its lowest level ever. This performance conceals a more complex story in the data. Since fear and greed has been replaced by relative ebullience on the back of superior global news flows, long-dated yields have started normalising. And this has destroyed fixed-rate bond returns: the Composite Bond Index has actually suffered a 0.74 per cent loss since August 16.

The floating-rate ASX hybrid market has been another standout, as it was in 2018, despite having to contend with the spectre of Labor removing cash refunds on franking credits. Once this risk was, as we anticipated, eliminated by ScoMo’s election victory in May, the risk premium required on hybrids quickly compressed by up to 100 basis points, driving strong total returns of around 7 per cent. Pity the poor souls who were advised to dump hybrids in 2018 and 2019 on the basis of the presumption Labor would come to power and/or control the Senate. They have suffered a similar fate to those who sold all their risky assets and went into cash during the darkest hours of 2018.

Where does this leave us as we head into 2020? The bottom line is that there are grounds for optimism in the forecastable short-term, which by definition means horizons of less than 12 months or so. As a result of the Fed’s rate cuts, the ECB’s quantitative easing, and expansionary measures by many other central banks around the world, there is a great deal more policy stimulus coursing through the global economic arteries than there was 12 months ago.

The pending US presidential election in November should take the trade war and tariffs off the table for fear of spooking animal spirits. Indeed, Trump’s trade truce means China has won a temporary reprieve from the fundamental economic decoupling sought by the bi-partisan consensus of geo-political hawks in Washington.

In the UK, BoJo’s comprehensive ascension removes another tail risk as he now has an unambiguous electoral mandate to consummate his proposed withdrawal deal from the EU.

And then there is the ongoing shift in the global intellectual zeitgeist away from fiscal prudence towards spendthrift deficits that will only amplify the inflationary impact of the cheapest money in human history. This is because nobody is worried about the downside risks of a future inflation cycle. The costs of near-zero interest rates and central banks artificially boosting all asset prices—supplanting markets in a new form of statism that is replacing capitalism—are allegedly non-existent.

One thing I have learnt in life is that when the human brain is confronted with an opportunity to take a short-term gain in exchange for much greater future pain, time and time again it makes the wrong choice. Hedonism always seems to prevail.

Read the full column here.