Please note: this article is more than one year old. The views of our team may have changed since it was published, and the data on which it was based may have been revised.
’Late cycle’ economies are characterized by slowing growth and increased market volatility, making it a good idea to protect your portfolio.
To understand what we mean by the term ‘late-cycle’ economy, it is helpful to look at how the economic cycle is supposed to work overall.
A ‘normal’ economic cycle has four distinguishable phases. It begins during a downturn, when consumer expectations are low, industrial production has fallen and interest rates are still high from the end of the previous cycle. Then it enters a second, recovery phase, as central banks initially cut interest rates to encourage growth and the economy expands.
The next, third phase is the peak of the expansion and in the past has not just been characterised by rising output, but also by rising inflation due to capacity constraints, leading central banks to raise interest rates to slow growth. Then, finally, in the fourth phase, another downturn begins as growth starts to slow – eventually hitting asset values, but not usually precipitating a market crash.
Generally, these sorts of economic cycles are not long-term and normally last between five and seven years, with the equity markets moving very roughly in sync. Corporate earnings are obviously sensitive to the economy and in periods of economic expansion, earnings are positive and hence equity markets perform well – although there are significant lags, as we discuss below.
What is unusual about this late-cycle economy and why?
The current economic cycle is unusual for three reasons. First, it has been going on for a long time. The U.S., for example, has been experiencing growth for just over eight years, which is a significant period of expansion in historical terms – although it should be noted, looking around the world, that the current period of expansion may have been long but it has also been weak. Now the growth of the world’s major economies is now decelerating, but each economy is decelerating at a different rate.
Second, the central banks’ policy responses are still conditioned by the after-effects of the global financial crisis that started in 2008 and the widespread disruption this caused around the world. Since the crash, central banks have been trying to normalize policy but have generally moved only very slowly.
As mentioned above, in most economic cycles central banks usually try to ‘put on the brakes’ when the economy overheats by raising interest rates. But this time it’s not working like that. Central banks in regions or countries experiencing poor growth are still not in a position to put up rates. One case in point is the European Central Bank (ECB) – until recently it planned to put up interest rates in 2019, but this now seems off the table. Even if the U.S., where strong growth had previously allowed interest rate rises by the Federal Reserve (Fed), growing uncertainty is now forcing it to be increasingly cautious in its policy outlook.
The Fed’s dilemma is that the situation may go one step further, or back as the case may be. Central banks, particularly in slow-growing regions, may have to go into reverse and seek more economic stimulus. This is something that China is now doing in earnest, with monetary easing by the People’s Bank of China (PBoC) complemented by fiscal loosening by the government. This does not fit the usual late-cycle narrative, where central banks would now be putting on the brakes.
A third reason why this late-cycle environment is unusual is that inflation is still very low, which removes one immediate source of pressure on central banks, but causes other policy headaches too.
So, we are in a stage of the economic cycle that has been going on a long time, and it is difficult to say how much longer it will continue. Because of this uncertainty, investors at this point are getting increasingly concerned that the U.S. economy will run out of steam at some point fairly soon – or that current policy will be reversed – and are thus reacting strongly to any perceived concerns around policy or geopolitical issues. This helps explain recent bouts of market volatility.
Why our advice to investors is to stay invested but hedge.
We may be in a late-cycle economy, and an unusual one at that, but our CIO team believes it will go on for a while longer before markets enter a potential downturn – the final consequence of the overall economic cycle. What is important for investors to remember is that historically, a late-cycle environment has often delivered decent equity returns, as well as higher volatility. It is important to remember that the market cycle is unlikely to be the same as the economic cycle.
Staying invested could therefore be a good idea, provided you are selective and provided you take steps to protect, or ‘hedge’ (in the broadest sense), your portfolio. Market rallies could be used as opportunities to reassess both risk management and related allocation strategies. While risk management may have some immediate costs, it makes sense to safeguard longer-term returns, particularly as market volatility seems likely to persist.
To find out more about navigating a late-cycle environment, please get in touch, or watch our video series, ‘Stay Invested, But Hedge’: