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It’s easy to see what caused a crisis after the event. In the ten years since the collapse of Lehman Brothers, regulators have overhauled the rules for banks, brokers and other market participants in an attempt to right the imbalances that triggered the financial crisis. But the steady, upward grind of the rally that followed has hidden powerful new distortions that have emerged in the years since the last global recession and which make predicting how this cycle will end almost impossible.
The most important change is extraordinary monetary policy. Financial markets that lapped up an epic tide of liquidity as central banks slashed rates to unprecedented lows and bought up assets will struggle as those flows dry up or are reversed. But other factors are also coming to the fore as the later stages of the business cycle loom.
Thanks to globalisation, economies are more interlinked than ever before. But trade frictions are escalating, geopolitical risk is rising and emerging markets are coming under pressure. Globally, there is a yawning bifurcation in economic growth and monetary policy. While growth largely follows China, global monetary policy is being set by the US Federal Reserve.
Against this backdrop, the key question is whether the end of the current cycle will be as peculiar as the rally that preceded it. While the longest (and some would say most hated) bull market in history may have further to run, investors will need to be braced for a potential shift in market leadership. The next iteration could bring increasingly irrational exuberance, a rotation to value, a combination of both or something else entirely. The time is right to rethink asset allocation for whatever comes next.
Navigating the shift from QE to QT
Chart 1: The Fidelity Leading Indicator suggests the trough could be getting near
Source: Fidelity International, August 2018
A decade of quantitative easing has meant that markets have broadly outperformed the underlying economy. Now, as quantitative tightening takes hold, spelling the withdrawal of monetary stimulus, markets may start to underperform the economy.
Corporate earnings are a swing factor. Performance has been strong but there are signs that earnings growth may have peaked - meaning more scope for volatility.
Chart 2: Momentum increasingly dominates the US rally
Note: MSCI USA net USD total return factor indexes, all rebased to 9 March, 2009. Source: Bloomberg, Fidelity International, September 2018
Price return, 12 months to:
MSCI USA GROWTH
MSCI USA VALUE
MSCI USA MOMENTUM
S&P 500 COMPOSITE
The current narrowness of the rally in equities is disturbing. A small number of stocks concentrated in the US tech sector have led the bull run. Meanwhile, momentum investing has dominated the market. Both could end and, in tandem, these factors increase the risks of a spike in volatility, which could be exacerbated by the shift to QT. While a narrow and momentum-driven market is a common late-cycle phenomenon, the typical exuberance has yet to arrive. And what comes next is even less certain.
Watching the Fed, China and Emerging Markets
There are signs the US economy has started running hot, which suggests a late cycle dynamic. The output gap has turned positive on a number of measures as the economy has started hitting capacity constraints. The labour market, in particular, is very tight and while inflationary and wage pressures remain contained by historical standards they are beginning to tick up.
Source: Fidelity International, US Federal Reserve Board, US Bureau of Labor Services, September 2018
A decade on from the crisis, a populist president is reshaping America. Donald Trump’s tax breaks are expected to fuel growth in the US economy throughout 2019. As the Fed gets increasingly concerned about overheating, it is likely to stick to its plan of hiking rates at a quarterly pace. But the three more hikes planned for 2019, further quantitative tightening and higher Treasury issuance might just prove too much for the US economy itself, and also for the rest of the world. At some point, the Fed might have to re-assess its plans, particularly considering a further negative impact on emerging markets from tighter US dollar liquidity. This is one theme markets will focus on in 2019.
Another is China’s growth trajectory. Beijing has been making some small, highly targeted policy easing measures designed to soften a slowdown and the potential fallout from the US-China trade war. This includes injecting more liquidity into the system by cutting reserve requirement ratios, prodding banks to boost lending and pushing down interbank borrowing rates. Effective as they have been, these measures are too small to engineer a meaningful rebound.
Source: China National Bureau of Statistics, Haver Analytics, Fidelity International, August 2018
Targeted deleveraging that discourages shadow finance remains the broad policy thrust while authorities attempt to encourage additional leverage in sectors of the economy considered good, like small firms and selected infrastructure projects that boost growth. We calculate these easing measures could boost infrastructure spending by as much as 700 billion renminbi (US$102 billion), helping to offset a downturn, but this would only bring spending in line with last year’s levels.
China’s policymakers could do more, but probably not without departing even further from the official deleveraging campaign.
And what of emerging markets, the source of extraordinary growth as well as crises in the past? It’s true that, relative to the late 1990s, today’s imbalances in EMs are smaller. Current account deficits have fallen as has sovereign debt, in hard currency terms. Yet tighter monetary policy in the US and a slowing China are putting pressure on emerging market economies. Companies issued debt to investors on the hunt for yield, much of it dollar-denominated, leading to an unprecedented build-up of private sector debt. Reduced US liquidity and the strong dollar is adding pressure on EM currencies to depreciate further, which in turn forces their central banks to tighten, weighing on growth.
Source: Fidelity International, Haver Analytics, National sources, Bank for International Settlements, September 2018
And those countries where fundamentals haven’t kept up with the massive wave of capital and where institutions haven’t strengthened are particularly vulnerable, as the recent volatility in Turkey and Argentina have shown. Even the US wouldn’t be immune to a large EM shock.
There are several potential triggers for the next global recession. A financial market meltdown is always a possibility, but why and when it would happen is unclear. A break up of the euro area would be cataclysmic, but the currency union appears to have weathered setbacks so far, including a recent political crisis in Italy. The trade war between China and the US could also be a catalyst, but so far it seems contained enough not to cause an unmanageable shock to global demand.
We may soon see a change in market leadership
The end of this cycle might take longer to play out than in previous downturns. We believe the equity market rally has more room to run, perhaps in unexpected areas. In fact, the market evolution from here might present as two cycles: the first driven by tech and strong US macro (which is the case now). But as tech valuations become increasingly stretched, a continuation of the rally may bring a second, coincidental cycle driven by a rotation to more traditional value areas of the market, which have so far been left behind.
It’s rare to see a rotation into value at this point in the cycle, but it would be another example of how things have changed over the past decade. Think back to the last expansionary cycle after the late 90s tech bubble - it was a long, shallow and value driven bull market that took us to the financial crisis. On the contrary, in the early stages this current cycle was driven by safe names and steady income generators. Only later did leadership pass to highly-valued growth stocks, like tech, which have been driven by expectations of very long term but almost incalculable future earnings. If market leadership passes yet again, perhaps from tech to value as we’ve suggested, it would mark a new phase in the cycle that would require quite a different approach from investors. In that sense it will represent an atypical late cycle - one that is driven by traditional value rather than animal spirits.
Very few observers spotted what was amiss in markets and economies before the last recession. This cycle has been odd from the start and the world still looks very unusual so the way it ends might not follow the usual path. There are some clear stresses weighing on the system arising from the US, China and emerging markets. But the current shifts in markets are more gradual than radical and our expectation is that any real transition in market leadership and widening of market breadth will require substantial changes in the economic cycle. Those could be next year’s problems. Equally, tomorrow’s opportunities look quite different from those of yesterday.