How Soon is Now?

No-one really seems to have enjoyed the current economic expansion and now, because it has been going on for several years, some are worrying about the end.

The typical end of cycle signs are there – rising inflation, higher interest rates, leverage and overvalued financial assets. But, really, they are all quite tepid. The Federal Reserve (Fed) is taking it easy. Europe’s recovery has only just got going. Inflation remains very low in most cases. The recovery won’t end just because it is old. Moreover, in the US it could be extended by tax cuts and spending. But there is a nag in the bond markets and that is valuations. That nag becomes a little bit harder to ignore if central banks begin to step away from quantitative easing (QE). Bonds are generally still expensive, but that only matters if the Fed needs to become more aggressive and credit risks start to increase. For the moment, fundamentals are good, confidence is strong and the policy environment is supportive. After years of worrying about everything because of the fear of a repeat of 2008, it is only now that more investors seem to be embracing the good times that we live in. Let’s hope it’s not too late.

Forever gloomy
The current economic expansion began in a dark place. Western economies had been to the brink of financial collapse. Falling house prices, banking failures and an evaporation in faith in the political consensus underpinning democratic capitalism inevitably led to a deep recession. The consequences of the crisis were far reaching and the after-shocks were plentiful – serial crises in Europe, a backlash of financial regulation and shifts in the political landscape that weakened the centrist consensus and delivered Brexit, Donald Trump and rising populism. The crisis and subsequent recession were so severe and existentialist that they have continued to be the major influence on investor, consumer and political sentiment, even today. In my view, this is why the expansion has never delivered any kind of feel good factor, why downside risks have continued to be emphasised over potential returns, and why central banks have felt it necessary to continue to provide extraordinary levels of monetary accommodation. Ten years ago, at the end of Q1 2007, the US Fed’s key policy interest rate – the Fed Funds Rate – stood at 5.25%. We are now around 7.5 years into an economic expansion and that rate is just 1.0%, even after three hikes. The shock of 2008 was so huge that it continues to affect us today – no-one wants to ever experience that again so everything is pretty risk averse and we share nightmares about that dark place triggered by “risks” like a Chinese hard landing, a collapse of the euro, a trade war or worse.

Where’s the party?
It has been difficult to enjoy the economic expansion. It might well have been a relatively long one by historical standards, but it’s been no party because anything worth worrying about always has that warning attached to it which says “what if”. Despite solid growth, an improved policy safety net and solid employment gains, many voters appear to express their desire for a different world and have little faith in the approach of “fixing” the system that delivered the crisis in the first place. Thus globalisation is rejected in favour of nativism. Trade agreements are being unpicked. The decisions taken by corporations about where to locate new investment are being driven as much by politics as by profit maximisation. Central banks are criticised for printing money and keeping interest rates too low at the same time as governments are being urged to spend, spend, spend. Orthodoxy, preached by “experts”, falls on deaf ears. Yet, the expansion continues. Growth is strong (forget the “now-casts” of Q1 GDP in the US, that is noise) and for once there seems to be more synchronisation in growth between the leading economic nations. Millions of jobs have been created in recent years. Even in the euro area, the unemployment rate has come down steadily since it peaked at 12.1% in 2013. Wealth has been created. The S&P500 equity index is up more than 250% in price terms since the satanically low level of 666 reached in March 2009. Bond markets have delivered very strong wealth growth and housing has recovered. Even the Fed is confident enough about the economy to be able to discuss the prospect of two more increases in the Fed Funds Rate this year and three to four hikes next year.

Who’s involved?
So even though it hasn’t felt it, this expansion has been long and strong. Investment strategies that have tilted towards owning risky assets have paid off, especially over the last year. Not that everyone’s has of course. Take the category of flexible bond funds. According to Morningstar data, total returns in the 1-year to the end of February amongst funds in the “Global Flexible Bond – USD Hedged” category ranged from +22% to -6%. Given that the main contributor to returns in the broader fixed income market have been sectors such as US high yield and emerging market bonds, it suggests that some managers have not participated in the global risk rally. So far this year, the more equity like parts of the fixed income market have delivered the strongest returns. High yield total returns are in the 1.5%-2.0% range and emerging market sovereign debt returns are close to 3.0%. US equity indices have delivered 6% price returns while European bourses have also seen index levels rise by over 4% in aggregate. I get the feeling that it is only relatively recently that more and more investors have become participants in the rally. During one of our fixed income forecasting meetings this week, it was pointed out to us by one emerging market strategist that equity investors have their lowest exposure, relatively, to emerging market stocks for a decade.

Is the end in sight?
Just as more investors might be getting convinced about the strength in the economic data, the more cautious amongst us are having to contemplate the end of the expansion. As I said, it is already long. There are plenty of late cycle features, especially in the United States. The unemployment rate is at a level that more and more economists think is consistent with full employment (notwithstanding the low participation rate). Inflation is starting to pick-up, interest rates are rising, leverage has increased and there are signs of rich valuations in a number of asset markets. None of these appear to be alarming at the moment and it was interesting to observe how positively the markets reacted to the latest in increase in the Fed Funds Rate considering that not much more than a month ago the market indicator of the probability of a Fed rate hike was very low. My take on the Fed is that the track it is on is to get the Fed Funds Rate up to where it estimates the likely “terminal rate” will be. According to the “dots” in the Fed’s economic projections, this is 3.0% by the end of 2019. I don’t see any reason why the Fed would feel it necessary to increase this forecast of the terminal rate given that most estimates of where the long-run equilibrium neutral rate are much lower than that. Indeed, anything that the Fed does to indicate greater “hawkishness” would probably defeat the object – markets would react badly and concerns about a negative feedback to the real economy would put the Fed on hold when it really wants to get rates higher. It is doing a great job at the moment, as illustrated by the fact that long-term bond yields are pretty stable. Typically, the end of a business cycle comes about because inflation rises and interest rates are increased to a level that starts to impact negatively on consumer spending and investment. Growth slows and, usually, a recession follows. For the reasons stated earlier, the Fed is desperate to avoid that so it is avoiding a rapid tightening of financial conditions.

Looking to DC
There is no natural time limit to how long a business cycle can last. They end because of a shock usually – either a monetary policy shock or some kind of demand or supply shock. While we may start to worry about the end of the cycle, one realistic scenario is that the cycle can be extended. Monetary policy is hardly tight in the US and is still aggressively accommodative in Europe, the UK and Japan. Emerging market economies are, generally seeing monetary easing. The big news since the US election is the prospect of fiscal stimulus in the US which would provide a boost to aggregate demand and extend the economic expansion. So far it’s not much of a fiscal boost and the reality of President Trump’s Administration to date is that the “swamp” still slows things down. Nevertheless, market are still expecting a fiscal boost. Until it comes the Fed will takes things easy. If it comes in size, the Fed might end up being more hawkish and getting to 3.0% more quickly than is currently envisaged. That would accelerate the peak of the cycle.

No natural end
Fundamentals and the policy environment do point to the expansion continuing. There have been lots of reasons why companies and consumers have been cautious, especially in Europe, and more animal spirits could help growth continue. However, from a market perspective there is something that is a major worry – the end of QE. While nothing dramatic is imminent, there are discussions about the Fed reducing its balance sheet over the next couple of years, perhaps beginning with a decision to end the re-investment of cash-flows. Many European economists expect the European Central Bank to reduce its monthly asset purchase volume next year and some are even talking of a hike in the deposit rate. The Bank of England’s (BoE) corporate bond purchase programme could be completed this spring. A reduction in the level of asset purchases from central banks must surely have an impact on bond prices. It would be some irony if the process of removing monetary accommodation because of a stronger growth outlook actually led to risk assets selling off. The US yield curve usually flattens very rapidly as a forerunner of a recession but that is because of a rise in short term interest rates. In the expansion phase, the gap between the Fed Funds Rate and 30-year yields has reached as high as 400bps in the past. Today we are at 214bps. If the spreads remain here and Fed Funds move in response to a fiscal boost to the US economy, 30-year yields well above 4% could be seen. And that changes the valuation metrics for equities. The end of QE could be the common factor that causes a valuation adjustment.

Carry on
Anyway, we are not there yet. One of the comments made during our meetings this week was that everyone knows the rally will end badly, but no-one knows when or why. In the meantime carry becomes a major source of expected return in a bond market where there is little conviction about short-term movements in price. We can put immediate concerns about the Fed on hold until closer to June and it is likely that “President Tweet” will keep talking about the upcoming boost to American growth. The Dutch election result put concerns about nativist populism in context and I think it remains difficult to see a Le Pen victory in France. So markets could keep on doing what they have been doing during the second quarter of the year with little evidence that the economic data is turning weaker. The mini-sell off in US high yield over the last month has pushed the index yield back to 6% and even European high yield is delivering 3.5% again. In emerging markets, the sovereign index yield is at 5.5% and, despite worries about US protectionism, the bottom-up story is quite good with recoveries underway in places like Russia and Brazil, and China on a stable path for the time being. Government bonds have much lower yields and the balance of risks is that yields still go higher. But high yield does offer a nice cushion against higher core rates.

Chris Iggo – Chief Investment Officer, Fixed Income – AXA Investment