The Economic Cycle is Dead!

As many investors may know, claiming that “this time it’s different” is the most dangerous four words in investing. With governments and central banks seemingly on the front foot to prevent the business cycle from a downturn or recession, it begs the questions whether this time it really is different.

As the ongoing bull market passes its 10 year anniversary since the GFC (global financial crisis), the ebb and flow of financial markets can be summed up quite easily by the actions from central bankers (most notably the US Federal Reserve), as well as the US-China trade dispute.

There have been numerous commentaries from great investors including Howard Marks and Ray Dalio, cautioning current investor behaviours, as the continuous market expansion use their emotion-driven decisions to justify ever increasing prices. In this newsletter, we examine whether the Fed (representing not just the US but all central banks) has the power or the role to keep expanding the economy and keep recession at bay.

Comments around interest rates being “lower for longer” has been around for some time and it seems like this is going to go on for a while longer. The fundamental idea of using interest rates to stimulate the economy is a generally accepted principle, leading to stronger economic growth, higher corporate profits and in turn driving up share prices. Share prices are also driven up immediately as low rates reduce the discount factor in calculating valuations. Although it took some time to gain traction, the low rates can be argued as being the main influence in rising asset prices over the past 10 years.

Finance 101 would have you believe that the downside of low interest rates is inflation. However, there has been almost no sign of that, and most market observers continue to point out that inflation is unlikely to spike anytime soon. So that begs the question – has the Fed done the unthinkable and contained the double whammy of inflation and higher rates at the same time? Have they been able to avoid the unthinkable and averted a series of little recessions and downturns?

Our View

We are in unprecedented times. We certainly do not believe that the business and financial market cycle is “dead.” The uncertainty that these unconventional steps have garnered are no doubt concerning. Famed investor and founder of Bridgewater, Ray Dalio, may have summed it up best when he recently commented:

“First, there’s a limited amount of capacity at central banks to be stimulative; second, we are late in the cycle; third, there are a lot of political and social conflicts within countries; and fourth, there is a conflict between China as a rising power and the US as an established power. Those factors will be the biggest drivers of economies, markets and geopolitics for some time. The confluence of those four forces is most similar to the late-1930s. We are in a period of exceptional uncertainty. It is unusually risky.”

Both Marks and Dalio have raised concerns that while the intentions of the Fed to ward off small downturns causes a lift a short-term price movement, there is limited ability for them to continue this without hitting a limit sometime in the future. Effectively, future returns have been brought forward. When that capacity has been reached, Marks warned that the recession could be a doozy!

The Fed can try to manufacture a smooth ride but their powers are limited by the very tools and levers they have on their hands. We all know that markets are complex machines and much of the ebb and flow comes from human nature and behaviour. How central banks continue to contain complex market powers is yet to be seen.

We therefore believe that taking big bets on any one idea in the current time can be a recipe for disaster. There has never been a more important time to diversify your exposure, stick to high quality assets, take a couple of uncorrelated exposures, have some income generation ideas and protect some of your capital by having some cash and liquidity.

If you wish to discuss any concerns about the current market or about any strategies to do with your financial plans, do not hesitate to call your Financial Adviser.