The Weekly - Where has the business cycle gone?

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07/08/2017
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A couple of weeks away on the beach does wonders for the investment psyche and helps put the all the noise into perspective. However, what is somewhat concerning is that there seem to be even more bears around than before embarking, willing a correction to occur. But corrections don’t just happen, there has to be a catalyst that is sufficiently scary that investors panic and prefer cash, earning negative real returns in the meantime.

Where has the business cycle gone ?

A couple of weeks away on the beach does wonders for the investment psyche and helps put all the noise into perspective. However, what is somewhat concerning is that there seem to be even more bears around than before embarking, willing a correction to occur. But corrections don’t just happen, there has to be a catalyst that is sufficiently scary that investors panic and prefer cash, earning negative real returns in the meantime.

As we all wait for this correction event with many on black swan watch having already moved to the side-lines, perhaps we should be thinking slightly differently. In this instantaneous communication age of social media, the investment community has more analysis and information than ever before, even on the beach, to make quick decisions. As media delivery has exploded, so has the creation of every doomsday scenario and its communication, defaulting to the negative as media stories always do. This means that investors could become complacent with discounting negative scenarios and when there really is something to worry about, initially this is missed and discounted as irrelevant. There is precedent for this at both the market peaks of 2000 and 2007 when the initial sell-off in TMT and sub-prime credit was ignored for a few months and interpreted by some as buying opportunities. Even Central Bankers, in the case of the latter, didn’t see what was coming. The lesson here is to always be vigilant and to never assume the consensus has an advantage in forming that view.

Measuring the business cycle

The one thing that is puzzling is the absence of the business cycle as we have historically known it. It is defined as the period between when an economy begins to grow in real terms as evidenced by increases in indicators like employment, industrial production, sales and personal incomes and the opposite when the economy is contracting and those same measures are decreasing. According to the National Bureau of Economic Research in the US, there have been 11 business cycles between 1945 and 2009 with the average cycle lasting just under 6 years. Knowing where we are in the business cycle is crucial for successful positioning of portfolios and most importantly, knowing where the market thinks we are relative to that, is where opportunities lie if there is a disconnect. Many at the moment think we have run off the cliff but are yet to experience gravity. Others perceive there to be no cliff anywhere on the horizon whilst others can see a cliff but are not sure how long it will take to get there !

If we have run off the cliff, then defensive positioning in stable cash-flows and dividend yields is the order of the day. Otherwise, stick with cyclicals such as commodities and technology as economic growth continues. The only trouble is, both parts of the equity markets look expensive. The former are bond proxies and with interest rates so low, these are vulnerable to rate rises whilst the latter have driven the US equity market, in particular, to new highs and sit on eye-watering valuations. Hardly an appealing choice.

Coming back to the business cycle, the current version is believed to have started in June 2009. This means that we are now over 8 years into this cycle with no obvious evidence to suggest there is a cliff approaching. However, if both defensive and cyclical areas of the equity market look expensive and bonds as well, the investor has limited options available to put the lion share of his asset allocation outside of the usual illiquid alternatives of property, infrastructure, hedge funds and esoterics. However, the first two of these also look expensive with discounts to net asset value at lows or premia, suggesting little value. This leaves hedge funds, other market neutral approaches and esoterics but these are not mainstream for the average investor and usually comprise no more than 25% allocation at most.

Asset Allocation

So what to do. Stay on the overvalued rollercoaster, hoping it will stop at a convenient time to get off, or get off now and sit tight waiting for the inevitable because it will come at some point. Trouble is, you may have to wait for quite a while and earn negative real returns as you do. For me, I would focus on those areas that still give a reasonable real return but will fall the least should a cliff suddenly appear. But perhaps we need to think in unconventional ways. Perhaps there is no cliff and the business cycle has been interrupted by all the Quantitative Easing. After all, outside of investors, very few feel better off over the last 8 years. Supposedly there has been economic growth and a recovery but to many, it feels like we are in a recession with austerity still restraining confidence and combating any real feeling of increased disposable income. Many consumers have rebased their monthly debt payments back to where they were before the credit crunch and on aggregate they are lower which feels comfortable. However, with interest rates so low, the actual amount of debt is considerably higher which means the effect of just a 1% increase in base rates could create a recession. A point not lost on Central Banks, hence their reticence to raise rates.

So perhaps the business cycle as we know it, being excessive confidence, overinvestment, boom followed by inflation, interest rate rises and bust will not occur. Perhaps we will see a prolonged sideways move in investment markets as they wait for the fundamentals to grind higher, assuming they do. Early releases of GDP data for Q2 have all undershot, not alarmingly, but there is clearly a softening even though the markets are unperturbed. The UK residential property market has ground to a halt for many reasons related to Brexit. Values will need to fall a long way before consumers become frightened as there has been so much wealth created over the last 8 years, the overvaluation buffer is huge and there is still a shortage of supply.

Even though it looks increasingly likely that Trump will fail to deliver much of his reflation agenda, the US equity market is trending sideways and underperforming globally. There is some justifiable scaremongering going on about UK dividend cover especially as earnings in some of the big FTSE payers have been boosted by Sterling weakness. When and if this reverses when we eventually secure a positive out of the Brexit negotiations, income defensives could be vulnerable.

So, if there is no cliff and the business cycle as we have historically known it is dead for now, perhaps we will just see low returns with low volatility with everyone looking at one another, nervously talking down the market. I suppose there is a possibility that a sink hole slowly opens up beneath our feet as dividends and earnings fail to live up to expectations. The key question is when and how deep ?

The Dow Jones passes 22,000 following robust US Labour Report

Most global equity markets made gains last week. In the US, the Dow Jones Industrial Average broke through another milestone in closing above the 22,000 mark for the first time. The S&P 500 made a much more modest +0.2% gain despite strong jobs data on Friday.

July’s US Labour Report surpassed expectations, with the unemployment rate slipping to 4.3%, matching its 16-year low. Non-farm payrolls data suggests an additional 209,000 jobs were created during the month. Wage growth though remains muted, a trend that has been entrenched for some time, with average hourly earnings holding firm at 2.5%. In aggregate, the data is likely to support the Federal Reserve’s intentions to raise rates again later this year and to begin unwinding its quantitative easing positions before the year is out. The yield on US Treasuries edged marginally lower, whilst the US Dollar appreciated against Sterling but was largely flat against the Euro.

The Bank of England chose to leave rates on hold last week at August’s Monetary Policy Committee meeting. Only two members of what is currently an eight-person voting committee voted for a rise in the base rate. This follows the departure of Kristen Forbes, whose replacement Sylviana Tenreyro was perceived to be more dovish and voted accordingly. The Central Bank also released its Quarterly inflation report and, in doing so, lowered its growth forecasts for 2017 to 1.7% (down from 1.9%) and for 2018 to 1.6% (down from 1.7%). Uncertainty surrounding Brexit was cited as the main reason for this. Sterling depreciated against most major currencies over the course of the week, falling -0.6% against the US Dollar and -0.7% against the Euro. The FTSE 100 climbed +2.0% during the week to close at a level of 7,512.

Other European markets also made ground, aided by last week’s initial composite estimate of second-quarter economic growth which was announced at a quarterly rate of +0.6%, in-line with expectations. Germany’s DAX 30 gained +1.1% and the French CAC 40 index climbed +1.4%

The price of oil closed the week largely flat. West Texas Intermediate crude oil prices briefly climbed above the $50-per-barrel mark during the week but later fell back. Brent Crude, the primarily European benchmark, closed the week at just over $52-per-barrel, down -0.2% for the week.

The Week Ahead

By recent standards, it’s a relatively quiet week of macro activity. Inflation is likely to garner most of the attention with headline readings from China, the US and the Eurozone. Domestically, the British Retail Consortium releases its version of retail sales tomorrow morning whilst later in the week there is some industrial production data. We also have an economic growth reading for the 3 months to the end of July as calculated by the National Institute of Economic and Social Research. There is nothing of significance from Japan this week.

Stock Focus

RELX Group (REL.L) Buy GVQ= 10 (3+3+4) Risk 3

 

The Group recently announced results (H1’17) that saw H1 Revenue at £3.72bn, above the consensus estimate was £3.68bn. Though 56% of Revenues are made in North America so Sterling’s depreciation versus the US Dollar has helped these reported revenue growth figures. This might not be quite the same in H2. It will also undertake digital asset acquisitions which it feels are appropriate and will dispose of any assets it deems are non-strategic, this is to help with the group's overall digital transformation. There is a threat from Open Access (some academic publishers can make their articles freely available online) and this may affect up to 25% of articles online but Relx's sphere of journals are well respected, and most of the Scientific Community who subscribe to Relx's publications cannot afford to wait for an article to become free or hope it does so, thereby protecting Relx's position. There has also been some concerns from some that in the auto sector, US miles driven have decreased, possibly affecting the Insurance Solutions segment, but the company has a habit of creating new tools for use and insurance premiums are still rising so should not present too much of a problem at present. The Risk and Business & Analytics unit appears best placed for growth. It has a PE of 18.9x (Dec ’18) and a 2.6% Dividend Yield which seems a little higher now but it does seem to be capable of doing the right things and overachieving still, so we remain confident.

 

Share price- 1675p Dec '18PE- 18.9x
Market Cap - £17.9bn Dec’18 Yield - 2.6%