Commentary: Navigating late cycle requires managing outside the mean

For investors, 2019 could prove to be a symbolic, possibly even seminal year. Should the U.S. expansion persist to the middle of 2019, it will set a new record for the length of a U.S. cycle; still well short of Australia's 27-year (and counting) expansion, but a notable record nonetheless. That is true especially when we consider some of the paradoxes that characterize this cycle.

Developed market policy rates are rising, yet remain below prior cycle troughs just as G7 unemployment rates are at 40-year lows. This S&P 500 bull market is the longest on record with trough-to-peak gains almost twice the bull market average of the last 50 years, but at the same time global equities have delivered gains about 6% shy of prior bull market averages. And just as technology is eroding geographic boundaries and functional barriers, trade protectionism may be forcing globalization into retreat, at least in the short term.

Against this backdrop, we are launching our 2019 long-term capital market assumptions. Presenting capital market estimates for more than 50 asset and strategy classes, we examine how some of the structural factors affecting economies today are likely to drive asset returns over a 10- to 15-year investment horizon.

This year's edition explores the challenges of late-cycle investing in a long-term context. Navigating late cycle demands that investors think and manage outside the mean. It may also require new portfolio construction tools that account for the wider spectrum of risks that investors will need to assume to drive future returns.

Our secular outlook is quite stable with risks broadly balanced between the well-understood drag from demographics and the potential upside from a technology-led pickup in productivity. Our 10- to 15-year forecast for developed market real GDP growth is unchanged from last year at 1.5%; we trim our emerging market estimate to 4.25% from 4.5%; our global real GDP forecast of 2.5% remains unchanged.

Asset returns at equilibrium look reasonable by historical standards. But cyclical risks are building, and many economies are operating above trend and with limited slack, while many asset valuations are elevated.

Bond return forecasts are a little higher this year, notably in the U.S. where policy normalization has created a favorable entry point. Ex-ante Sharpe ratios for U.S. government bonds now meaningfully exceed those of U.S. stocks for the first time since the financial crisis. Global equity returns are unchanged; we lower our forecast for U.S. equities by 25 basis points to 5.25% and raise our estimate for emerging market equities by 50 basis points to 8.5%. Expected returns for a U.S. 60% equity/40% bond portfolio are slightly better, up 25 basis points to 5.5%, entirely driven by higher expected bond returns. Alternatives are a relative bright spot, as fee reduction and improved alpha trends lend support to returns.

In last year's edition of our long-term capital market assumptions, we described ourselves as secular optimists but cyclical realists. Our secular optimism is undiminished even as cyclical headwinds have increased this year — leading us to contemplate how to manage our portfolios as the storm clouds gather. We also note that some of the factors which might hasten the end of this cycle could also have gradual but profound effects on the economic and investment landscape over the long term. Indeed, the very nature of the cycle itself may well be changing, and with it the causes of — and remedies for — recessions. Debt levels and the size of central bank balance sheets create new challenges for policy and could ultimately compromise central bank independence. At the same time, the structure of the capital markets is evolving, generating new sources of return, and risk, for investors.

Looking ahead, a recession is virtually inevitable over the next decade and likely to occur sooner rather than later in our 10- to 15-year horizon. Many investors fixate on the precise catalysts and shape of the next downturn — and specifically on avoiding it. Yet market timing is notoriously tricky. We believe that focusing on staying in the game through a contraction and evaluating the possible contour of the next cycle is the more effective approach over the long run.

Navigating late cycle demands that investors think and manage outside the mean. This entails not only optimizing to market risks evident in our traditional mean-variance frameworks, but also recognizing the risks they don't capture and, most importantly, ensuring those are compensated. Differentiating among those dislocations that may be persistent, rather than merely stubborn, is critical in understanding the secular economic and investment environment.

We imagine that it is in policy rates where persistent dislocations are most likely to arise, as flatter cycles less sensitive to stimulus hold policy rates below equilibrium for long periods. This could in turn stoke asset prices, driving future rounds of asset inflation without associated price inflation. New technology trends only serve to further contain price and wage inflation, even as they boost real growth and productivity. To the extent that such an environment reinforces economic inequality, the temptation for governments to borrow to fund fiscal stimulus is a good reason to think that national debt levels are unlikely to mean-revert anytime soon.

In our view, policy rates, government balance sheets, market structure patterns and inflation trends all represent structural shifts in the investing environment that a simple mean-reversion framework is unlikely to capture.

To help meet these challenges, investors will be well served by focusing on more active investment in secular themes such as technology, and the growth in alternative assets, as well as ensuring all elements of risk — not merely market risk — are appropriately rewarded. Navigating late cycle doesn't mean avoiding risk, but it does mean knowing the risks being taken.

John Bilton is head of global multiasset strategy at J.P. Morgan Asset Management, London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.