Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 317

From macro to micro: end-of-cycle investing

As the US economic cycle continues to age, many are starting to question when — and how — it will end. Although we don’t believe the length of the economic expansion by itself should be a concern for investors, one of the big questions we have heard recently is: “When is the US going to have the next recession?”

We are not trying to predict or time a downturn, but there’s no doubt to us that we are near the end of a very long economic cycle. The economic cycle fluctuates between periods of expansion and contraction and each is marked by certain characteristics. The peak of a cycle marks a time of maximum output, typically accompanied by imbalances which need to be corrected. Following that peak thus comes a contraction, then a trough, or recession.

What is a recession?

A recession is a decline in economic activity for two consecutive quarters. This can occur for a number of reasons, including an increase in the cost of capital or a decrease in access to capital.  A significant rise in inflation is a major culprit, leading to an increase in the cost of money and rising interest rates as central banks use monetary policy tools to combat it. Other factors, including plummeting trade, a drop in consumer confidence, speculative bubbles or exogenous events such as natural disasters can trigger a recession.

Historically, when the United States economy was manufacturing-based, recessions happened when inventories got too big. Over the last 20 years, as the United States has moved more into a service-based economy, there isn’t that same inventory dynamic. So, I don’t think we can conclude a recession is imminent just because the current expansion is longer than it has been in the past.

It’s true that the expansionary phase of the current US economic cycle has been running much longer than what is typical, now more than 10 years from the last trough in 2009. However, Australia has the record for the longest expansion—now more than 20 years.

As far as we can see at this point, it doesn’t look like a recession is going to happen within the next year or two, so we think the US expansion can continue. That said, we think investors should certainly be prepared for the cycle to change.

Positioning an equity portfolio for late cycle

Equity markets tend to be leading indicators of the onset of a recession. Fearing a downturn in the cycle, market participants start to revise their expectations, and this is reflected in lower stock prices. Our analysis shows that the average lead time between the start of an equity drawdown and the start of a recession is eight months.

However, there can be false signals. Obviously not every equity market decline leads to a recession; for example, the recession of 1980 was not preceded by a significant equity market pullback.

Sectors that can shine

In many ways, our approach to end-of-cycle management is similar to our regular investment approach. We remain focused on building portfolios that we believe should be poised to benefit from multi-year secular growth themes or innovation.

We take a long-term view and leverage our bottom-up research to identify businesses that have dominant brands or franchises with high-quality management teams, healthy financial returns and a track record of resilience. We are avoiding high-debt companies, while targeting companies with strong cash-flow generation.

Meanwhile, it’s important to recognise that traditionally, different sectors have responded differently during recessions. Consumer staples, health care, energy, materials and utilities sectors have a history of outperforming the market in periods of decline, as these goods are relatively inelastic. For example, during a recession, consumers will cut back their spending in areas such as entertainment or air travel, but not likely on things like toothpaste or electricity.

Global diversification

By most analysis, the United States is at a later stage of its cycle than other countries, so we are alive to opportunities globally in terms of diversifying our portfolios.

European markets tend to do well late in the cycle, due to their high exposure to inflation- and rate-sensitive sectors like commodities and financials, which tend to outperform in a rising price and interest-rate environment.

European companies have been vastly under-earning their US peers while trading at historic valuation discounts, offering scope for both profit improvement and multiple expansion as policy conditions normalize.

Value stocks have often become more attractive in a recession

Volatility in the global markets is currently near-normal levels, and we look at that as an opportunity. Value investors are looking for mispriced stocks, and when there’s not a lot of volatility, you don’t get a whole lot of mispricing. But as investors pull their money out of the market, they tend to pull it out somewhat indiscriminately. That indiscriminate selling often creates mispricing of stocks based on their fundamentals. Value investors look for opportunities to step in and take advantage of that mispricing as volatility increases.

That said, we believe both growth and value investment styles can be well-positioned for the cautiously optimistic scenarios we see. The outlook for corporate earnings growth looks positive to us, as does the outlook for global economic growth in 2019.

Focus should return to stock-picking

In my opinion, over the last few years, many equity investors have been thinking about the wrong things.

Traditionally, equity investors would look at earnings when seeking out viable companies to invest in. However, the last 10 years of accommodative central bank monetary policy have made a lot of investors more macro-oriented, rather than micro-oriented. We think these investors should go back to looking at the differences in individual stocks and not be so focused on the actions of central banks, particularly the US Federal Reserve.

While we don’t see a near-term recession, that doesn’t mean we think stocks will always continue to rise. To have a healthy bull market, you have to have volatility and the occasional pullback or correction. Ultimately, we focus on companies that have good quality earning streams.

 

Stephen Dover is Head of Equities at Franklin Templeton. This article is for general information purposes only and does not consider the circumstances of any person, and investors should take professional investment advice before acting.

 


 

Leave a Comment:

     

RELATED ARTICLES

Investing throughout economic cycles

Recession and why timing markets doesn't pay

What does the shape of the yield curve tell us?

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

Policy proposals allow young people to access their super for a home bought from older people who put the money back into super. It helps some first buyers into a home earlier but it may push up prices.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.