Batten-down-the-hatches?

We recently received a number of questions from investors on whether we thought the economic and capital market cycle is coming to an end. Basically, is it time to ‘batten down the hatches’? The UK’s uncertain post Brexit trading position was another source of concern, with some fears going as far as anticipating the reappearance of 1970’s style capital controls. After years of quite pleasing investment returns, there is clearly a growing private investor sentiment of ‘should I take what I have and run before the pain begins in capital markets?’

We discussed in last week’s lead article how the slowing of global economic growth, together with a return of some inflation, is currently having a sobering effect on stock markets world-wide, following their short but concerning fling with ‘irrational exuberance’ in January. This week’s postponement of a second rate rise by the UK’s central bank (Bank of England / BoE) on grounds of diminishing economic growth and inflationary pressure has added to the sense that all is no longer well in the global economy.

Donald Trump’s renewed assault on global diplomatic consensus by withdrawing the US from the Iran nuclear deal, which took 10 hard years of negotiations, adds to the fear of potential unwelcome external shocks. After opening the prospect of a trade war with China in April, his pouring of oil onto the lingering flames of the tensions in the Middle East now increases the possibility of military conflict between the various regional hotheads. Predictably, the price of oil hit a new high for the year – its highest in 3 ½ years.

What was our answer then to the queries, in light of all this disconcerting news-flow? Well, as always, it was to take a step back and point investors to the bigger picture. We see that picture by asking how likely it is that the current economic cycle will come to a sudden end, which would lead to falling corporate profits or losses. While activity levels are undoubtedly slowing, and this cycle is now the second longest of the last 100 years, it is worth remembering that cycles do not ‘die of old age’.
They come to an end either because of (1) economic overheating, (2) central bank policy errors or (3) external shocks. The 2008 Global Financial Crisis (GFC) and the 1970 oil price shock are prime examples for the external shock scenario (3). The premature hiking of US interest rates in 1994 are the most cited example of a recent central bank error (2) causing recession (although we would argue that central bank’s complacency during the pre—GFC structured debt bubble could also be seen as a policy error). All remaining cycle ends go back to the well understood boom to bust overheating scenario (1).

What’s the likelihood of any these three causes happening soon? In our view, overheating is not a big risk, given the recent return to very pedestrian rate of economic growth. Nevertheless, the tightness of labour markets that leads to cycle-ending levels of runaway inflation can be observed in some western economies, particularly in the US. However, it is not (yet) leading to particular inflation pressures – possibly because businesses can so far maintain their profit margins without pushing up prices through productivity enhancing capital goods investments and employees’ reluctance to change jobs in search of better pay.
Wage developments need to be watched because they can often cause inflation, but the latest uptick in inflation to the 2% (in the US) was caused by oil price increases, not wages.

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