The underlying investment story since the stock market’s trough in March 2009 has been investors no longer believe in the business cycle. Each cycle has unique characteristics and catalysts, but history shows well that business cycles still exist and tend to follow a very common pattern.
The current business cycle, contrary to popular belief, has both existed and followed the typical course. The current cycle, however, has been elongated. The economy developed more slowly than investors expected, but the cycle nonetheless had early- and mid- cycle periods. Whereas economists have largely been disappointed by this cycle’s anemic growth, investors have benefitted greatly from its muted, but abnormally long path.
We commented many months ago that the US economy was entering the late-cycle phase. Investors again ignored the business cycle and the signs indicative of a late-cycle period. In particular, investors disregarded the inflation pressures that were building.
Inflation expectations have been rising since mid-2016 (see Chart 1), yet flows into bond funds and ETFs went unchecked.
The recent market volatility seems to be a result of investors finally realizing that the business cycle isn’t dead. Later-cycle inflation is becoming more obvious, and the market has needed to recalibrate valuations, earnings expectations, and asset allocations to the suddenly “new” inflationary environment.
Inflation Expectations : 5 Yr 5Yr Forward Breakeven
(Weekly, Feb. 13, 2013 – Feb. 7, 2018)
The elongated cycle
In 2010, RBA suggested that the bull market might be one of the longest in modern history, and positioned our portfolios accordingly. We thought the cycle would rejuvenate, but it would be elongated because of the constraining effects of the deflating global credit bubble. Early-cycle sectors tend to be very credit-sensitive (housing, autos, and retailing), but credit conditions remained tighter than normal even as the economy recovered. The combination of unusually tight credit standards, fiscal policies that were contractionary, and increasing financial regulation and oversight limited early-cycle growth. The positive though was that the economic boom often sought by politicians was replaced by slow consistent growth that proved to be investors’ nirvana.