We’ve reached the peak of the business cycle, is it downhill from here?
We’ve reached the end of what has been an incredibly quick business cycle. Are there only negative surprises to come?
Growth has recovered, and it’s strong. Inflation is at a 20-year high. We are now at the peak of the business cycle. Is it all downhill from here?
Recently, economic data surprises have been incrementally downbeat—not quite as many jobs added; inflation a little bit higher than people expected, industrial production a little bit lower. Investors have started asking themselves, Will growth start to slow? Are we already approaching the early downturn section of the business cycle?
The first thing to understand is that this so-called negative data isn’t all bad. In truth, given the current situation, a certain measure of inflation is in fact desirable to help pay down some of the debt accumulated from this, and past, economic crises.
The chart below depicts the debt-to-GDP ratio of the US. It’s high, at 130%. And the ability to pay it off is dependent on economic activity. The more activity a country has, the higher its capacity to service that debt. To get GDP to rise, a country needs to see either ‘real’ GDP growth (people getting richer) or ‘nominal’ growth, which is driven by inflation.
Chart 1: Debt now equates to 130% of US GDP
Source: Bloomberg US Treasury
Let’s take a look at what’s happening in the gas and electricity markets. Early autumn saw consumers battered by a surge in energy costs globally. This is the latest manifestation of inflation: too much money chasing too many goods. After a year of Covid shutdowns followed by a flood of re-activity, we are simply trying to produce too much stuff. Excess amounts of energy are required to do that; this surging demand has filtered through into power prices.
There’s another, encouraging reason behind this as well: the shift to a greener economy. We’ve decided as a global society to move to clean energy production, which tends to be more costly; this is manifesting in higher electric and gas prices. These higher prices, borne of both a more enlightened outlook on energy and the aftermath of the Covid crisis, represent a headwind for real economic growth over the next six to 12 months. So how will we account for this in our portfolio? The economic backdrop suggests higher-for-longer inflation—2% percent seems more a floor than a target. A lot of the growth that we’re going to see will be driven by higher prices for goods and services.
Therefore, we’ll continue to position for structurally higher inflation. We also accept that there may occasionally be market events where there’s a short-term setback. Investors should seek to carve out a segment of their portfolio that can capitalise on those events should they happen. Invest in essential rather than discretionary businesses, and retain your ability to deploy capital on weakness.
Investment view: Bonds—No Time to Buy?
For all our talk about the global recovery and the speed with which markets shrugged off Covid’s economic contagion, the truth is the fiscal terrain remains pretty rocky. Bonds have always been the favoured safe haven of investors. But have we reached a point where even the most benign buys represent too much risk?
First, a quick reminder of what happens when you buy a bond: you, the investor, are essentially lending money to a company or government, with the promise that you will be paid back, hopefully with interest, at a set date in the future. In other words, you are a lender, and the issuer of that bond, be it corporate or sovereign, is indebted to you.
As you can see from the chart below, yields (or the amount of money you earn on that initial investment) have been less than exciting as of late. During the darkest days of Covid—the spring of 2020—yields on the typically less volatile UK 10-year gilt drifted alarmingly close to zero.
Chart 2: UK government bonds have fallen in the past five years
But an immoveable truth remains: bonds are still less risky than equities. When markets get tumultuous, bonds are the instruments that will hold up better. Positioning, however, is key. In an economic environment such as this, where the threat of recession lurks just below the surface and GDP could fall flat (or even simply fall), bonds can still protect a portfolio and serve as a source of funds to buy equities should they fall. However, if you lend money to the government for 20 years at close to 0%, at the end of those decades you have lost purchasing power; a substantial portion of your capital will have been eaten away by inflation. The solution is to invest in shorter-duration bonds. Lend to a company on a three-year basis, and it’s likely you’ll get your money back in three years with some interest to compensate for inflation. Should inflation force interest rates higher, then you can lock in higher yields when the time comes to reinvest the principal.
And inflation isn’t going anywhere. As mentioned earlier, a certain level of inflation is likely desirable to the powers that be. The Autumn Budget, announced on 27 October, made it clear that the UK government’s aim is not to pay back the money it’s borrowed over the course of the pandemic and other crises. The plan is to pay a low level of interest for long enough to let inflation erode the value of that debt.
In recent months, yields have inched back up, creating a headwind for bond investors. If the upward climb continues, central banks could introduce yield-curve control, meaning they’d purchase bonds with newly printed money, an act that would ultimately raise inflation.
Even with so-called ‘safer’ bonds, always be discerning. Growth forecasts for developed markets are constantly tracking lower, and expectations are fast heading toward flat for the final quarter. In corporate credit, seek out well-managed companies. Buy bonds with nearer maturity dates that are unlikely to experience the economic surprises and increasing inflation that time so often brings.