Where are we in the Economic Cycle?

Updated: Jul 26, 2019

Introduction

I would like to start off by saying that this article is in no way supposed to be used to speculate on the current or future economic cycle, and should also not be used to make changes to any investment portfolio. Please speak to your financial advisor on any changes or concerns you may have.

The purpose of this article is to more or less help shed light on my current views and why I personally believe downside protection to be one of the most important factors in all investment portfolios. Currently, one of my largest concerns is that we are nearing the peak (or are potentially already at the peak) of an economic cycle. On top of this concern, there are many factors subsequently at play that I view as important as they have the potential to magnify any economic stress going forward.

I would like to stress again, that you do not use this article in any way to make decisions in your own portfolios. Speak with your advisor. It is important to plan, but do not speculate.


The Economic Cycle & Why It Is Important

The Economy tends to move in periods of economic expansion followed by economic contraction. These fluctuations, which can directly affect the value of investments over time, are known as the business cycles. The term cycle may suggest that they are regular and predictable, but it is important to realize that they are not. This is a large reason as to why we shouldn't speculate when an expansion or contraction will begin. There are, however, Leading, Coincident, and lagging indicators that can help us determine where we are and what we can potentially expect.

We are currently in the second-longest expansionary period ever recorded and although these periods do not just die from old age, it is important to realize the length amassed and assess it with other information.

Especially during the peak of an expansionary period, I believe we need to focus less on making portfolios look theoretically good return wise on paper, and focus more heavily on downside protecting features such as funds that hold more cash, avoid overly leveraged companies, a disciplined and unwavering valuation and due diligence process, hold less exposure to cyclical companies, and to work with the portfolio managers that have proven their processes in other contractionary periods.

The asymmetry of losses and returns helps explain why we need to focus on this philosophy. Especially during peak segments of economic cycles. For example, if our portfolio were to have a max drawdown of 50%, we would need to achieve a return of 100% just to get back to where we were (Calculated as [1 / (1 - %Loss) – 1]). Whereas if we were to work with portfolio managers who were actively positioning their portfolios with an emphasis on downside protection and were potentially able to achieve a maximum drawdown of 15%, we would only need a 17.6% return to get back to ground zero.

(The example above is just that; an example).

There are never any guarantees when it comes to investing in companies or funds, but it makes sense to plan and then stick with that plan.


Potential Magnifying Factors

Now that we have a general understanding about economic cycles and why they are important, let us look at some of the key factors that could amplify any form of economic stress.


Consumers

U.S. Household Net worth, when compared to U.S. household income, is at unsustainable levels. In fact, assets have been artificially bid up under the catalyst of low-interest rates providing cheap debt. We haven't seen levels of net worth to income like this since 2007 before the global financial crisis that caused it to decline.


Corporations

U.S. Non-financial corporate debt is at a higher level than its peak before the global financial crisis in 2008. A decade of low growth and very low interest rates has been the catalyst in companies acquiring massive amounts of debt. Now that central banks are starting to normalize rates, it will become increasingly more expensive to maintain and take on extra debt to fuel growth. Currently, Moody's reports that 60% of all non-financial corporations are now rated as speculative (Below Baa) and this number is likely to increase with economic stress.

Now the scenario isn't as ominous as it was a few months ago as Moody's released an update stating that if we consider Net non-financial corporate debt (Debt – Liquid assets) to GDP, liquid assets have been outgrowing the current amount of debt being taken on. That debt is largely held in deposits and money market instruments making it highly liquid with low volatility. Although this is a welcomed update, it is still important to be wary in my opinion. With the current rising rate environment, Growth could stall and debt will become more expensive. One of our investment firms has also recently reported that interactions with corporate management across many different companies has proven to them that the management of many companies do not fully understand the risk being taken on.

This all combined could potentially set the stage for a large number of defaults during the next period of economic stress.


The Central Banks

Central banks are signalling a path to higher interest rates. Now, this can be achieved alongside GDP and corporate profit growth, but it could also as mentioned choke off growth. One of the larger concerns for the investment firm mentioned above is the spread between the 2-year and 10-year U.S. bond yields.


This is known as the 2-10 curve and has been a reasonable indicator of recessions in the United States since the 1950’s. Currently, it is at its lowest point since right before the global financial crisis in 2008.

Central banks have been normalizing their rates, and the cheap debt we have seen for ten years has artificially driven growth. This has resulted in record debt levels for both corporations and consumers as mentioned above. This has inflated asset values & weakened the global economy’s ability to withstand economic stress.


Conclusion

I don’t think I can stress enough that it is imperative to not speculate and make rash movements regarding the economic cycle. However, it is important for us to use the information available, analyze it in a non-partisan manner, and plan for the future. I see too many that try and turn a blind eye towards any form of negative news. That isn’t planning…

The most important factor when we invest (in my opinion), is the quality of the company’s and funds that we invest with. We can, however, use macroeconomic information to help position our portfolios to steer clear of certain problems. Combined, this should greatly increase our chances of reaching our future financial goals.

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