It's the economic cycle, stupid!
In many end-of-year market commentaries, you’ll see phrases like 'the FTSE has held up relatively well' or 'the S&P has really suffered this year'. But there’s something weird about these phrases that get missed.
What they are actually saying is that…
- an arbitrarily chosen group of stocks…
- weighted and rebalanced idiosyncratically…
- in geographies you could slice up in any number of ways…
- over a time period determined by a rock spinning around the sun...
…has done x, y, or z.
Sounds like a lot of randomness when spelt out like that, right? And it tends to mean that people reading the commentaries focus on the wrong things:
First, the timeframe – humans obsess over calendar years. For long-term investors, the key market driver is the economic cycle.
The global economy and the slow-moving factors that impact it don’t care about the Gregorian calendar. The coronavirus wasn’t waiting until the earth moved around the sun to spread, and Putin didn’t invade Ukraine because of his New Year, New Me resolutions.
Second, the actual indices. The S&P 500 didn’t underperform the FTSE 100 simply because it’s a collection of the 500 largest US-listed stocks. It wasn’t the size of the companies or the location of their headquarters that mattered. The S&P underperformed the FTSE 100 because, on average, S&P stocks were more technology-focussed, trading at higher valuations, were more sensitive to rising rates, and didn’t have the same energy exposure. Yet we insist on linking indices to countries.
We know that the S&P massively underperformed the FTSE this year. But if you take the biggest ten stocks out of both indices and calculate the returns of the remaining stocks, the results are completely different:
|S&P 500 excluding top 10||-8.8%|
|FTSE 100 excluding top 10||-9.8%|
So, there really isn’t a simple story for each index. Taking big tech out of the S&P, and a few hefty blue-chip energy and materials stocks from the FTSE, means the indices respond to economic conditions very differently. As forward-looking strategists, understanding the drivers of the economic cycle allows us to make more nuanced forecasts than just picking indices.
Why are we talking about this now?
We are heading into a new part of the economic cycle. Things will be different, and it’s our job to create a picture of what we think this cycle will look like. This picture doesn’t care about indices or annual timeframes. Only once we have this picture can we form our best view on which assets we want in our portfolios – Ahmer Tirmizi discusses this later.
To compare the last economic cycle with what lies ahead, let’s strip down the old cycle versus the new cycle into data points that we can monitor:
Recent high levels of inflation have really hurt, but context is always important. Since the turn of the millennium, we have got used to abnormally low inflation in the developed world. Going from below-target inflation to 40-year highs has felt extreme, but over the next cycle, we will have to get used to higher trend inflation.
Right now, shocks are still having a very real impact on the economy and inflation – things aren’t normal. Huge Covid stimulus packages led to demand-driven inflation, and Russia’s invasion of Ukraine led to volatile and uncomfortable supply-side pressures.
After 2008, the factors keeping inflation low were longer-term. Banks were made to sit on more cash so lower rates didn’t kickstart inflation the way textbooks say it should, and the economic slowdown was drawn out. The factors at play now should be viewed very differently. Stimulus will pass through the economy, and the supply-side constraints will ease.
We believe inflation will settle at a level above the pre-Covid norm in the coming years.
The rates story is similar to the inflation one. Since the 80s, rates have been coming down very consistently in the major economies. And since 2008, rates have been really, really low. Again, this is not normal, and it certainly isn’t something companies, consumers and governments should have got so used to.
Central banks have their feet on the brakes. They are determined to kill inflation, and the data are starting to turn.
But central banks will be in no rush to get rates back to the historic lows of the 2010s – they’ll take this opportunity to press the Reset button. In the 2010s, central banks could not use interest rates as an expansionary policy tool once rates hit zero. By renormalising interest rates in a 3-6% range, central banks will regain their ability to put their foot on the accelerator when the next slowdown comes by meaningfully cutting rates.
This is harder to forecast, because there isn’t as much of a return to normal as there is with inflation and rates.
In the short term, most economic leading indicators are saying a recession is just around the corner. The yield curve has dramatically inverted, and consumer confidence has taken a knock. Perhaps more importantly, central banks are willing to embrace a recession as the lesser evil versus inflation.
But the story is not all bad. Economies work in cycles, and we expect growth over the next cycle to be higher than what we have seen post Global Financial Crisis. The recession we are heading into is not the GFC. Systemically important companies are not on the verge of collapse, and the largest part of the average individual’s wealth – property – is not in crisis.
The shorter-term factors that are causing this recession will soon go away and are not likely to cause a recession as deep or painful as the one following 2008.
The coronavirus wasn't waiting until the earth moved around the sun to spread, and Putin didn't invade Ukraine because of this New Year, New Me resolutions.
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