Pity this business cycle — it looks older than it actually is. By some valuation metrics, the recovery might seem long in the tooth, but output gaps, inflation dynamics and central bank policies all scream "midcycle" as events unfold that favor continuing growth.
The new U.S. tax law is an example. Unlike the tax cuts under Presidents Ronald Reagan and George W. Bush, which primarily reduced individuals' tax rates and stimulated demand, the latest cuts primarily benefit corporations. If companies act as anticipated and meaningfully step up their investments, output gaps would remain balanced, keeping us firmly midcycle. Greater investment also could slow the gentle rise of inflation and give central banks space to rest once monetary policy normalizes, instead of lurching into a restrictive mode.
The odds the tax-cut savings will be invested and not returned to shareholders is high. But instead of being invested the traditional way (in capital goods that expand capacity), this capital is likely to be applied in ways that bolster capability. Essentially, many companies have plenty of capacity now but are worried that, after years of not investing in their businesses, they are vulnerable to new competitors. After nearly a decade of being rewarded for financial engineering and hoarding cash, CEOs now are being compelled by competitive forces to make well-crafted investments in technologies and capabilities aimed at keeping disrupters at bay.
The significance of this shift in management direction can't be overstated. The absence of corporate investment during the past decade has been a drag on global growth and a primary contributor to the collapse in productivity. It lowered macro growth to the point of engendering instability. At the same time, the safety-in-numbers aspect of not investing when competitors also laid low enhanced micro stability. Each of these patterns is now reversing. Stepped-up macro growth will be accompanied by stepped-up micro instability, which will lead to more defensive investments and more macro growth.
And let's not forget China. While U.S. companies were buying back stock and paying special dividends, China stepped up its investments. That action is now bearing fruit, with a visible transition from capital-intensive and heavily polluting industrial investments to services and consumption. A successful shift in China's economic mix lowers deflationary risk for the global economy and reduces implied risk premiums, making China a quiet but important contributor to this midcycle viewpoint.
A global trade war is certainly a risk that, should it materialize, would be detrimental to the outlook for global growth. Yet for now we anticipate more noise than long-lasting damage, and ultimately, negotiations of terms of trade rather than an overhaul of the global trade system.
The greater possibility of this economic cycle having a way to go leads to several implications for investors.
Conditions favor equities. The stage is set for several years of accelerating corporate earnings globally. Although central banks around the world are normalizing monetary policy, global excess liquidity will dissipate only gradually due to years of unusual credit creation and the post-crisis global savings glut. This implies discount rates that will rise more slowly than EBITDA, which is bullish for discounted cash flows. Since equity markets continue to embed elevated risk premiums, abating fears of a China stumble and a continuation of growth will allow those premiums to shrink.
Developed-market sovereign bonds are less appealing. The monetary policy normalization that began in the U.S. is now spreading. The European Central Bank, which began the signaling process in 2017, will end quantitative easing toward the end of 2018 and start raising rates in 2019. Although the Bank of Japan will be the last to tighten policy, it, too, appears to be signaling a tilt toward normalization sooner than previously expected. Developed-market sovereign bonds, therefore, are very vulnerable.
The capital structure's sweet spot shifts. Credit assets were the primary beneficiary of the post-crisis period, punching above their weight in term of returns. In the face of rising yields and already tight spreads, increased corporate spending on capability-enhancing technologies and processes will bring about a peaking in free cash flow. This is an important driver for corporate spreads, even as accrual-based earnings rise for years to come, which is important for equities. In this environment, investors are likely to benefit from moving up the capital structure into floating-rate instruments such as bank loans and investment-grade tranches of collateralized loan obligations.
Recovering countries are increasingly attractive. Economies on the path to recovery but with considerable slack in their labor markets are prime candidates for above-average cash flow growth. Considerable slack remains in peripheral Europe, for example, where pent-up investment demand will translate into strong earnings for domestically focused and smaller companies due to high operational leverage. Brazil, too, presents opportunity, having exited one of the deepest recessions in its history last year but still having considerable capacity to grow.
Opportunities in productivity-enhancing technology. Technological disruption is coming to practically all sectors, which means providers of technologies used in cloud computing, fintech and automated processes are likely to enjoy years of attractive growth.
Financials are uniquely attractive. Since investment cycles must be financed, a decade of deleveraging and reregulation has set the stage globally for the financial sector to begin growing again and return capital to shareholders. U.S. financials are most attractive, but don't overlook the Europeans. As rate hikes come into view, domestic growth supports loan growth, and Basel IV provides the regulatory certainty that can trigger a re-rating of the sector.
Volatility will rise. Quantitative easing's impact in the form of capital deepening and lack of capital investment created micro stability of cash flows, which caused market volatility to wind down. These forces now are slowly reversing, indicating a return of volatility, which should rise in all asset classes over the course of the recovery.
