As we approach the sixth year of the current economic cycle there are constant reminders of just how unusual it has been by past comparison. The dramatic fall in the oil price, renewed conflict in Ukraine, the political backlash against austerity in Europe, the European Central Bank’s announcement of quantitative easing, and lenders having to pay borrowers to take their money in a number of countries have added to the sense that we live in abnormal times.
Growth has generally remained stubbornly sub-par despite highly stimulative monetary and fiscal conditions. China’s spectacular growth rate has stuttered and the commodity boom has turned to bust. In a more normal cycle this would be the time when investors would be worrying about diminishing capacity, overheating and monetary tightening, the kind of conditions that normally bring the party to an end. At such times investor sentiment has typically been euphoric, whereas, despite strong performances of developed market equities and bonds in local currency terms, this time sentiment has remained brittle. As the Doors’ Jim Morrison once sang, these are indeed “Strange Days”.
So what is 2015 likely to hold and where are we in cyclical terms? The world economy labours in the twin shadows of the global financial crisis and the natural end of the long Chinese boom. The former weighs heavily on the developed world, whereas the latter continues to depress the emerging world. Caught in such cross currents, individual country cycles are highly desynchronised, evidenced in weak commodity prices and persistent deflationary pressures. Debt levels that many thought would have to decline — the “new normal” — have done the opposite. Deleveraging is missing in action. However, there is a strong case against excessive future pessimism. The gestation period has been a long one but the key US economy appears to be on track. Consumers have retrenched, the banks have been recapitalised and are now lending normally, and consumer sentiment, having shown gradual improvement, has rocketed over the last six months.
Lower oil prices, if sustained as we think they will be, are like heavy rainfall after a drought and will provide a substantial boost to US consumers and others. The dollar’s dramatic rise against all world currencies since July 2014 appears to have been a barometer of the change of gear in the US economy, suggesting that it was already emerging from the more general slough of weak growth before the effect of weak oil prices was felt. Certainly the rapid contraction of the formerly buoyant energy sector in the US and the disruptions at its west coast ports may obscure the trend in the near term, but in our view, the expansion is sufficiently broad-based to stay the course. In time this will help provide more general global economic traction, resulting in growth finally exceeding consensus expectations. In the cases of Japan and the eurozone this could happen sooner than economic forecasters suspect in response to the lagged impact of material currency weakness and other stimulatory measures.
Such a backdrop remains constructive for markets. True, increasingly divergent monetary policy trajectories are likely to result in higher volatility, but a steady and improving growth picture should usefully underpin corporate earnings growth, while low inflation and continued loose monetary policies out of the US should keep real short- and longterm interest rates low. Against such a background developed market equity valuations are reasonable and equities should deliver positive returns. Developed market bonds may even extend their secular bull market to an incredible 34 years. European, US and Japanese property assets should also be well supported.
Emerging markets may experience a bumpier ride. Equity valuations are relatively cheap, at least in aggregate, but operating performance remains poor and we suspect that currencies may need to adjust further. After the end of a long cycle it would be unsurprising if there weren’t a few high profile casualties before it is safe to declare the all clear. Typically, new emerging market cycles are incubated in periods of reform and India may point the way here.
To conclude, it is too early to call the end of the current cycle. It is likely to be an unusually long one with several more years to run. Jim Morrison also once proclaimed that “this is The End”, but this is a sentiment we do not agree with.
Lower oil prices … are like heavy rainfall after a drought