Investment professionals have for many years employed the concept of an ‘investment clock’ to determine which asset classes perform best in the various stages of the global economic cycle and interest rate changes. The post-Covid-19 cycle has been decidedly challenging to navigate, however, with investors continually adjusting their expectations amid different economic scenarios as policymakers work to steer us back to price and growth equilibrium.
Nonetheless, over the past year, the market has grown more confident that we will achieve a ‘soft landing’ with inflation returning to target while growth remains stable. Sentiment has been further boosted by optimism around AI adoption, although this is concentrated in a select few companies.
IS THE CLOCK TICKING?
Over the past two months, there have been several market movements suggesting that the cycle is progressing. First, we’ve seen some of the AI euphoria cooling as investors have started to question whether the massive amounts of capital that companies are spending on the technology will be justified by returns. While labour market data was still pointing towards a buoyant economy and inflation cooling (raising hopes of interest rate cuts), investors started to look towards other parts of the market that had been left behind, such as small caps, to drive the equity market higher.
Then, earlier in August, a combination of data releases suddenly shook investor confidence in the soft-landing narrative, resulting in a mini sell-off as leveraged traders rushed to unwind crowded positions in a relatively low liquidity period. Economic data suggested that the US labour market had started to weaken, raising the chances of a US Federal Reserve rate cut. At the same time, the Bank of Japan (BoJ) rather unexpectedly raised its policy rate.
Traders had for years been taking advantage of the low interest rates in Japan by borrowing in yen and investing in higher-yield markets – referred to as the yen carry trade. This was a profitable trade given the persistent weakening of the yen. However, with the interest rate differential expected to start shrinking and traders exposed to a reversal in the yen, the unwind of the carry trade was set in motion. While most major central banks have been tightening over the past two years, the BoJ has continued to be a supplier of cheap liquidity in the global financial system, which is now at risk of reversal.
On Friday 9 and Monday 12 August, markets entered panic mode. The Japanese equity market had its biggest one-day fall (12.2%) since 1987, while safe-haven assets such as US Treasuries rallied. The VIX Index, a measure of expected volatility for US equities, reached a level of 65 – the highest intraday level since March 2020. The market was at risk of plummeting into a downward spiral. However, the fortunate timing of subsequent labour and economic activity data releases during the same week calmed investors’ nerves, at least raising hopes that weak job statistics could potentially have been impacted by seasonal factors and didn’t necessarily point to an economy heading for a recession.
Across the Pacific, Japanese policymakers would also have become more aware of the wider implications of their planned monetary policy normalisation, which will likely lead to a more cautious approach. In the equity bull market that began in October 2022, buying the dip has proven to be a profitable strategy, driving investors to get back into the market to avoid the risk of missing out. This resulted in the market quickly recouping losses, even though the current cycle seems to be getting long in the tooth. So, might it still be too early for Mr Wolf?
SHIFTING GEARS
We have argued that the path towards a US soft landing would be challenging given the huge amounts of stimulus injected in response to the Covid-19 panic, which led to an overheated economy that required cooling in order to resolve the inflation problem. To date, the resilience of the US economy in the face of sharply rising interest rates has surprised many. However, it’s important to remember that monetary policy works with long and variable lags. We’ve previously outlined the reasons why we think interest rates have taken longer to impact the US economy compared to other regions, including the prevalence of fixed-rate debt and looser fiscal policy.
As mentioned, it is not possible to predict when ‘dinner time’ will be called on the market. There are simply too many uncertain variables impacting markets in the short term. For us, it is more important to try to understand the bigger investment cycle in which we operate, and construct portfolios that are resilient to a variety of outcomes and deliver returns over the long term.
From an investment cycle perspective, indications are that we are most likely in what we would call the late-cycle market phase for the US. This is characterised by relatively high valuations on elevated profit margins, above-average inflation and high interest rates. In the bond market, credit spreads are tight, meaning that investors require low premiums for taking additional credit risk due to a positive view of the economy.
The recent market weakness coincided with a rally in US Treasuries, a sign that it was driven by growth concerns. This contrasts with the other post-Covid-19 equity drawdowns when US Treasuries sold off alongside equities due to rising inflation worries. Furthermore, the past couple of months saw defensive sectors such as consumer staples, healthcare and utilities start to outperform, which is also typical of a late-cycle pattern.
While slowing on the margin, economic data does not yet suggest an imminent severe recession. US consumers are benefiting from a strong labour market and healthy balance sheets at the higher end. Companies are, however, noticing more value-conscious shoppers and increased strain at the lower end of the market due to high living costs and the impact of high interest rates on consumer debt.
We may be entering a period of higher volatility, with the market becoming more sensitive to day-to-day data releases as it tries to understand the durability of the economic cycle. Unfortunately, short-term data is often noisy, adding to the volatility until the trend becomes clear.
At Sanlam Private Wealth, rather than trying to time the cycle, we assess the risk and reward prospects of assets in different economic scenarios. At present, high valuations, investor positioning and earnings estimates, as well as tight credit spreads, suggest that the global equity market has already priced in a soft landing. This increases the downside risk should this narrative fail to realise. On the other hand, the fixed-income market appears to be pricing in a more aggressive rate-cutting cycle over the next year than would likely be expected in the absence of an economic slowdown.
PORTFOLIO IMPLICATIONS
In the face of volatility, it is in our view crucial to build resilient, well-diversified investment portfolios with assets that can provide performance across various market scenarios, including hedges against geopolitical risk. Fortunately, the high interest rate environment has created more opportunities to build better-diversified, higher-yielding portfolios.
Our view of the cycle suggests a tilt towards low-risk fixed-interest investments and more defensive, high-quality stock selection. The late-cycle phase will no doubt test investor discipline due to fears of missing out on the rising equity bull market. However, it’s probably wise not to provoke Mr Wolf when it’s getting late in the day.
