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Robustness, Flexibility and Opportunism in Late-Cycle Investing

Why Is Late-Cycle Investing So Challenging?

When the market starts to anticipate the next downturn, in our view it does not necessarily pay to beat the rush by adopting an underweight in risk assets. While the late stage of the cycle is a time of corporate balance-sheet deterioration, that buildup of leverage can propel a final burst of earnings expansion. Mature cycles have often been characterized by a late surge in equity and credit markets, and missing out can compromise long-term performance.

At the same time these market dynamics not only tend to generate a great deal of volatility, but also cause bouts of strong correlation between equity and bond performance, making it increasingly difficult to manage overall portfolio risk. Alternative investments such as hedge funds or alternative risk premia strategies can help with this—but that merely reinforces the message that the direction for traditional assets is radically uncertain and the need for nimbleness, tactical trading and flexibility is paramount.

The fundamental late-cycle investing challenge is, therefore, to maintain exposure to growth without losing control of overall portfolio risk.

Why Might the Late Stage of This Cycle Be Especially Challenging?

We think this challenge could be especially acute in the mature stage of the current cycle. One reason is that, whereas government bond yields have tended to be high during the late stages of past cycles, a decade of central bank intervention and concerns about long-term growth and inflation have left them low or even negative. The more cautious investor therefore has no obvious place to go when they underweight their equity allocation.

But there is more to it than that, and to understand why, it helps to think about how the turn in this cycle is likely to play out, and why it may look different to previous recessions. In short, we believe it is likely to be longer but shallower: the slowdown may be less severe but the recovery may be much slower and weaker. That has important implications for market dynamics in the lead-up to that downturn.

The Next Downturn May Be Longer and Shallower

Two things happened during past recessions. First, the economy endured a severe shock from one of four sources: inflation, energy supply, manufacturing-sector inventory imbalances or financial imbalances. Second, the economy recovered thanks to meaningful fiscal and monetary-policy interventions from government and the central bank underpinning a restoration of consumer and business sentiment.

Next time around, there may be two contradictory forces at work: on the one hand, during the past two recessions central banks have shown increasing willingness and capacity to intervene to curtail meaningful economic downturns; on the other, the capacity for a fiscal, monetary or mortgage-finance stimulus may be limited.

We think the next downturn could be longer-lasting, therefore, because it's not obvious that we have the tools to fight it.

While we anticipate a longer downturn than usual, we also think it could be shallower. In fact, rather than asking when the next recession is likely to arrive, it might be better to ask whether it will arrive at all. That is partly because of the willingness of central banks and government to intervene much earlier and more strongly in response to signs of stress than in the past, perhaps due to the realization that they have weaker tools with which to address a more severe downturn. Witness the actions of the Federal Reserve and the European Central Bank in response to minor market volatility during the first quarter of 2019, and the fact that the U.S. has been expanding its deficit at a stage when it would have been tightening it in previous cycles.

But our anticipation of a shallower downturn also owes a lot to structural changes in developed economies. We think the causes of the last dozen or so recessions in the U.S. economy can be grouped into four categories

1. Inventory imbalances occur when reduced demand leaves manufacturing companies with excess stock, forcing them to cut back production and labor and feed into a vicious cycle of falling demand.

Our View: The development of just-in-time inventory management and flexible labor markets have made these kinds of recession less likely as time has passed.

2. An inflation shock can cause a recession or sharp slowdown by forcing central banks to tighten monetary policy rapidly, which can have the unintended consequence of draining the economy of liquidity and suppressing confidence.

Our View: While we think higher and rising inflation could be a feature of the next few years, structural trends such as globalizing labor markets, demographic ageing and automation are likely to continue to make the economy less susceptible to inflation shocks, as they have over the past two decades.

3. In Energy shocks, an interruption in supply of a key commodity pushes up input prices for manufacturers, and ultimately consumer prices, leading to a temporary fall in demand.

Our View: Energy shocks look increasingly unlikely in a world that relies much less on OPEC countries for its energy, due to advances in the production of shale oil and gas and the growing importance of renewables.

4. Financial imbalances and asset bubbles have become more impactful since the 1990s, after a 50-year break following the Stock Market Crash and Great Depression of the 1930s.

Our View: The structural changes that have made other recession catalysts less likely have elongated recent business cycles, and in general, the longer cycles last, the more financial risks begin to build. Post-financial crisis market liquidity is fragmented, corporate and government debt is higher than ever, market volatility and government bond yields are near all-time lows, stock markets are near all-time highs and credit spreads near all-time tights—all of which raises the probability of disruptive price dislocations.

Amplified Market Volatility—And a Recession That May Never Come

We argue that the fundamental late-cycle investing challenge is to maintain exposure to growth without losing control of overall portfolio risk. In our view, as this cycle matures and turns it may never be advantageous to adopt all-out “late-cycle defensiveness”, but markets will still be characterized by high volatility, potentially deep sell-offs and a growing risk of financial shock—and that makes the challenge especially acute.

Four Principles for the Late Stage of This Cycle

In our view, these four principles can serve as a helpful guide through the late stage of any cycle—but they may be especially important during the turn in this highly unusual one. We think they encapsulate some of the best ways to survive in the event of a worse-than-expected outcome, while also providing the ability to thrive on the combination of fractured liquidity, volatility and shallow underlying growth that are likely to characterize the next downturn.

1. Distinguish Signals From Noise

How can investors tell when late-cycle is turning over into end-cycle? In illiquid markets that have been distorted by QE-distorted, indicators based on price movements in financial markets are compromised. Investors need to look past these, and remain focused on fundamental economic indicators.

2. Re-Assess Strategic Asset Allocation

In the past, maintaining growth potential without losing control of overall portfolio risk meant using equity rallies to rotate into government bonds. We believe that strategy is unlikely to work this time around. In a low-yield world, investors should recognize the importance of diversifying genuinely, not cosmetically; across regions and styles; and onto less-crowded paths.

3. Identify Through-Cycle Themes

One way of dealing with cyclical investment challenges is to look for investments whose performance is not primarily determined by the business cycle, or whose dynamics supersede or “look through” that cycle. Examples might include the mega-cycles of emerging markets or long-term growth themes such as artificial intelligence and 5G connectivity.

4. Be Ready to Provide Market Liquidity

The next downturn will be the first since the financial crisis of 2008 – 09. That is significant, because a post-crisis wave of regulation has left the structure of the financial market very different than it was going into previous recessions. Illiquidity poses risks, but may also generate opportunity for those prepared to provide market liquidity.

Final Thoughts: Late-Cycle Investing Takes Us Back to Basics

While each cycle is different and each stage of a cycle is different, we think these principles of thoughtful asset allocation, true diversification, risk awareness and robust governance take investors back to basics. Our principles for late-cycle investing are not meant to delineate the “right” allocations to make or even the “right” sort of portfolio to adopt. Instead, they indicate the right sort of questions to ask of your governance structures, your flexibility and your adaptability as an investor, at the point when they are likely to face their most stringent test. Making portfolios robust against the volatility of the cycle (“surviving”) is also about maintaining the ability to pick up value opportunities that look through the cycle (“thriving”).

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