Productivity rise called chief reason to believe market still has upside
Money managers are becoming increasingly convinced that the end of the business and economic cycle might not be as nigh as some investors anticipate.
Optimism over productivity around the globe, particularly in the U.S., is the key reason for their faith in the current bull run in markets, lasting almost a decade already.
Because some investors are on tenterhooks, awaiting a downturn and positioning in a risk-off way, money managers say they are finding opportunities for investment.
"Last year was the first year since the financial crisis where we had strong, positive growth in all regions globally," said Hani Redha, London-based multiasset portfolio manager at PineBridge Investments, which runs a total $90.5 billion in assets under management. "The drags on the economy are fading — private-sector deleveraging is over and the debt overhang from the crisis has been worked off. We always saw (the period of low growth) as temporary — we never thought it was the 'new normal.'"
PineBridge executives think the market sees the recent boost to growth as a temporary thing, something "not worth paying for. It means valuation multiples have actually come down, because earnings growth has been so strong," Mr. Redha said, referencing recent 25% earnings growth in the U.S.
With valuations materially lower year-to-date, he said, "that is telling you that the market thinks this is a blip and we will then go back to the old days of low growth. And that means opportunities for us."
That's not to say there aren't testing times to come for markets, with volatility expected over the next few months in particular. Managers highlighted the Italian budget process, with the government set to outline new targets and a draft budget over the coming months; the next round of tariffs from U.S. President Donald Trump; Brazil elections in October; and U.S. midterm elections in November.
"But we don't think any of these things really change the strong undercurrent working its way out. We are in a real minority (in thinking) that things are midcycle," Mr. Redha said.
Number of factors
There are a number of other factors to keep watching in markets when assessing just what could bring the cycle to an end.
"There are clearly candidates which could cause a market shock," said John Stopford, London-based head of multiasset income at Investec Asset Management. "Oil-price spikes have been a fairly frequent source of instability in prior decades, and could be so again if Iranian supply is badly impacted by sanctions. But this time increasing trade tensions may be a more likely shock to earnings if these continue to escalate without any agreements being reached."
Mr. Stopford said trade wars are still at an early stage, but need watching.
"Overall then, the risks appear to be building steadily, but there looks to be a reasonable chance that this long bull market can continue to run for another six to 18 months or perhaps even longer. There is clearly an opportunity cost of getting out either too late or too early," Mr. Stopford said.
Investec's approach is to gradually scale out of equities and equity-linked markets, but to retain some additional participation through call options, "which currently offer a cheap way to benefit if the market has further to go on the upside," he said.
There also are a number of ways of assessing where the markets are in the cycle.
"Simplistically, people use the term 'late cycle' in a macro sense to say we've had nine years of growth, the average length is 'X' years, and therefore we must be nearer the end," said Stuart Kirk, head of global research institute at DWS AG in London. "Others use the term as a less scary way of suggesting what they really mean: that markets are expensive but may go up some more before crashing."
He said a more sophisticated way of thinking is to look at macro and market indicators, deciding which are late, mid- or potentially early cycle. "The trouble with this approach is macro and markets are often two sides of the same coin," Mr. Kirk said.
Mr. Stopford said "history suggests that this bull run is very extended, but also time alone is not likely to cause it to end. Similarly, a perception that equities, especially U.S. equities, are expensive has dogged the market for much of the last decade but has yet to end the rally, and it would be unusual for extended valuations by themselves to cause stocks to sell off."
And Andrew Milligan, global head of strategy at Aberdeen Standard Investments in Edinburgh, said it is important to look at the factors that would normally bring a business cycle to an end — typically that "there are some forms of imbalance, and those imbalances tip the economy over the edge. Traditionally that has been inflation … (or) it can be a shock from other sources, as we saw in the 2008 crisis."
However, he said inflation is not really a worry, with U.S. inflation running at 2.9% in July — albeit its highest level since 2012; private-sector debt is not a particular concern in most countries; and while trade "could blow up into a proper trade war, so far (we are) seeing skirmishes here and there. So I keep returning to what brings it to an end? The imbalances aren't there," Mr. Milligan said.
Focusing on productivity
While those imbalances do not seem to exist, what is being noted by some money managers as a sign to markets having further to run is a tick-up in productivity.
"If you are late cycle, companies find it very hard to grow at 20%-plus. Inflation is still pretty subdued, and the most interesting thing we are watching is productivity. Everyone we talk to completely writes off that we will get productivity, but there are some really interesting trends developing," said Mr. Redha.
The trend is starting in the U.S., but will spread, he said.
"It is mainly to do with technology — there are technologies that were being developed and commercialized but not adopted on (a) large scale. Now CEOs (of corporations) have had a change in mindset — they cannot wait and are scrambling to put these things in place. Shareholder demands have changed such that they cannot just do buybacks," he said.
For DWS' Mr. Kirk, productivity is the only thing that really matters in the cycle debate. In the situation of a productivity surge, there emerges "a beautiful, virtuous circle where wages go up, growth is strong, inflation is (subdued) and bond and equity markets do well," he said.
A change in nominal wages in any economy has to equal the change in prices, plus the change in productivity, plus the change in the labor share of output or the inverse of margins, Mr. Kirk added.
"So if nominal wages are rising, as they are now, something has to go up on the right side of the equation to match." The only way to have a rise in wages without inflation — which is bad for bonds — or a collapse in margins — which is bad for stocks — "is for productivity to go up," Mr. Kirk said.
He added that he is "fairly bullish on productivity" and expects management teams to innovate, invest more cleverly and think about new technologies in order to drive profits and growth.
Mr. Kirk said DWS executives are more or less aligned with a "latish-cycle view," remaining overweight equities, neutral to constructive on fixed-income and positive on real assets. "But we spend a lot of time debating this topic. If I were to guess, we probably reckon this cycle is going to extend for longer than consensus."
Question for investors
The question for an equity investor is whether higher productivity, as seen in the U.S. and starting to trickle through to other markets, is priced into markets, he said.
"No matter what you say, most developed equity markets are expensive. But in classic late cycles, real assets such as stocks can go from being very, very expensive, to very, very, very, very expensive," Mr. Kirk said, citing the Nasdaq's doubling in 1999.
"That late phase of a rally is often so extreme that if you don't participate you end up looking silly indeed. That's what people are worried about right now. The question is whether this is a pause year before a classic final rally, such as in 1998, or whether these markets have another five or six years due to a new productivity surge," he added.
And Mr. Redha said PineBridge has been finding opportunities related to productivity.
"Productivity is like pixie dust for the market — it is disinflationary growth and extends the life of the cycle. We have added new themes (to PineBridge's multiasset exposure)," with one dedicated allocation to productivity," Mr. Redha said.
"We start with companies providing corporate-facing technological solutions — those that adopt them will benefit too — but we are starting where some companies are spending their IT budgets, more on the software side such as cloud, but some hardware," he said.