Where are we in the cycle?

Since early March shares have climbed a classic wall of worry with fears about everything from debt deflation to policy stimulus causing hyperinflation.

However, an important issue is how any short term cyclical rebound in shares will fit into the medium or longer term trend.

Short term cyclical recovery

The typical short term investment cycle lasts around three to five years from trough to trough.

During an economic downturn or recession, government bonds are the place to be, but eventually monetary and fiscal stimulus start to sow the seeds of the next economic recovery.

Shares normally anticipate this and start to move up about six months before the economic recovery actually occurs. This is the period in the cycle where shares climb the classic ‘wall of worry’, as there is still much uncertainty about whether there will be a recovery or not and how strong it will be.

As a result there are usually a few setbacks along the way as this uncertainty about the recovery occasionally resurfaces. This is probably where we are now. This eventually gives way to a ‘sweet spot’ in the cycle where growth expectations are recovering but inflation and interest rates are still low and stocks are cheap.

After a few years or so, inflation starts to build and interest rates rise up to onerous levels setting the scene for the start of the next cyclical downswing in shares which leads the next economic downturn. It’s likely the current cycle will follow a similar trajectory.

However, several points are worth noting. Firstly, while this cycle has been unusual in terms of the pressure to reduce high debt levels following sharp falls in asset prices, the unprecedented fiscal and monetary response has provided an offset, holding out the prospect of a ‘normal’ cyclical recovery. The odds, of which have been enhanced by signs that lower interest rates and fiscal stimulus have got traction in terms of better economic data, defying the skeptics.

Secondly, past recoveries have often seen bond yields spike higher initially as investors suddenly start to factor in an economic recovery, inflation worries and monetary tightening. But this usually proves to be premature as inflation tends to keep falling well into an economic recovery and central banks normally take longer to start tightening than first thought. The same is likely to be the case this time around, so the next six months are likely to see bond yields fall back or stabilise after their recent spike. This should take pressure off mortgage rates.

Short term worries about the impact of higher mortgage rates and oil prices, ongoing bank issues, capital raisings, rising unemployment and uncertainty about the strength of the recovery are all likely to ensure that the ride for shares over the next few months will be more volatile than the last three months have been. Note also that the period from now to September/October is often rough for shares.

So the current correction may have further to run. However, our assessment is that shares have likely commenced a cyclical upswing and are likely to have more upside over the next year or two. Shares remain attractive compared to low yielding cash and bonds, most investors are still with underweight shares and a further improvement in economic data (albeit not in a straight line) is likely as we head towards an economic recovery from later this year.

The longer-term picture

An important issue though is how the current cycle fits into the medium or longer term trend for shares. In the 1970s, and in Japan in the 1990s, there were cyclical upswings and downswings but they were relatively short in duration and occurred in the context of below-trend economic growth and a secular or long term bear market in shares.

In this context it’s worth noting that US and European shares have in fact been in a long term or secular bear market since 2000 and Japanese shares have been in a long term bear market since 1990. The US share market has experienced several long term bull and bear phases over the last century. The last secular bull market in US shares started in 1982 and ended in 2000 when the tech bubble burst.

The key drivers of the 1982-2000 secular bull market were: the fall in inflation which allowed shares to rise faster than earnings, easy credit, an increasingly stable macro economic environment, de-regulation and smaller government, globalisation which helped keep down inflation and boosted trade, the IT revolution and favourable demographics.

These considerations helped drive well above average investment returns from 1982 on the back of strong profit growth and rising price to earnings multiples. For example, from 1982 to 2000, US shares returned 20% per annum. For many countries this strength continued into 2007. For example, Australian shares returned 16% pa over the 1982-2007 period which is well above its long term average return of 12%.

However, since the turn of the century many of these favourable themes have faded or gone into reverse, which is a dampener for share valuations and long term profit growth. In particular:

• The benefit to shares from the shift to low inflation over the last 25 years has run its course.
• The aftermath of the global financial crisis will likely ensure a tighter credit environment for the next decade or so, and still-high gearing levels, made worse by falls in house prices in the US, provide both a constraint and a degree of vulnerability going forward.
• The need to unwind the unprecedented monetary and fiscal stimulus that has been undertaken worldwide to combat the global financial crisis will likely contribute to a more volatile economic cycle. This will be a major issue in the next few years. Withdraw the stimulus too quickly and there is a risk of a relapse into economic downturn, as Japan saw in the 1990s. But exiting too slowly could risk inflation and much higher bond yields.
• The policy pendulum is now swinging back in the direction of more regulation and greater government involvement in the economy. This could adversely affect economic dynamism and productivity growth.
• Demographic trends are becoming less favourable as the proportion of the population at peak spending age starts to decline and baby boomers start to retire. Poor population growth in Japan and Europe are additional constraints in these regions.

The bottom line is that while the recent low in shares provides good long term opportunities for investors, when it comes to mainstream global shares (US, European and Japanese shares) the broad backdrop is not as positive as was the case at the start of the last secular bull market in 1982.

In fact the more difficult fundamental backdrop today suggests, while we may have entered a cyclical recovery in shares, the medium term trend in US, European and Japanese shares is likely to remain weak and average medium term returns are likely to be around 5-8% pa. The combination of still high private sector debt ratios, pressure to reduce gearing levels and the need to unwind very easy monetary and fiscal policies will also likely result in a more volatile economic and financial cycle, similar to that
experienced in the 1970s.

Investment implications

A number of implications flow from this. Firstly, the key for investors will be to invest in markets which don’t suffer to the same degree from high debt levels, demographic constraints, and exit problems associated with high public debt and very easy monetary conditions. Asian and emerging markets generally are high on the list on this front.

It’s worth noting that while US shares have been in a long term bear market since 2000, the trend in Asian shares has been strong. This is likely to continue. Thanks to Australia’s trade links to strong growth in Asia, better demographics and a better public debt situation, the medium term return from Australian shares is likely to be somewhere in between the strong gains from Asian shares and the more constrained trend in the US.

Secondly, in a world of potentially big divergences in the medium term return potential between asset classes and shorter, more constrained investment cycles, asset allocation will likely be far more important than has been the case over the last 25 years when most asset classes had strong gains and asset allocation was less significant.

Thirdly, the macro economic environment will be far more important for the management of equity, property and credit investment portfolios than has been the case from the early 1990s until recently, when recessions where mild and tended to be many years apart.

Conclusion

While there will be setbacks along the way, shares have most likely embarked on a cyclical upswing that has further to run. However, various structural constraints mean that for US, European and Japanese shares, this should be seen as a cyclical bull market in the context of an ongoing weak longer term trend. We are also likely to see shorter, more volatile cycles. Investors should look to overweight countries that don’t face these same constraints. This includes Asian and most emerging markets and, to a lesser extent, Australian shares.

Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.