A version of this material originally appeared in the Financial Times on 17 April 2018.
The global economic expansion has already entered its 10th year. With bumpy and brittle growth having given way to a robust and globally synchronized conjuncture, an aging cycle has suddenly become much more cyclical.
Alas, late-cycle booms typically mark the beginning of the end. As spare capacity erodes and central banks focus on removing accommodation, the risk of accidents in the real economy or in financial markets is rising. Thus, it is time for investors to prepare for a potentially long period of more volatile and plateauing asset prices, because it often precedes bear markets for risky assets.
To be sure, there is nothing in the economic data or financial indicators to suggest that a global recession is imminent. Unlike in the past few cycles, consumers have been relatively thrifty, house prices do not look excessive and the corporate sector has not overinvested in fixed capital – if anything, the opposite has occurred. Also, financial conditions remain favorable despite recently higher equity market volatility, and fiscal policy is expansionary, especially in the U.S.
Recession over the horizon?
Against this backdrop, barring a big geopolitical event or a full-blown trade war, the global economic expansion appears to have room to run for another year, or maybe two. However, the risk of a recession soon thereafter is high and rising.
One reason for elevated medium-term recession risks is that U.S. fiscal stimulus comes at the wrong time of the cycle because the economy is already operating at or close to potential. This raises the risk of an inflation overshoot, which could be amplified by rising commodity prices in response to globally synchronized growth. Needless to say, import tariffs, if they were to be implemented broadly, would also stoke inflation, at least initially, and hurt real income and GDP growth.
Of course, one would have to worry less about potential inflationary consequences of late-cycle fiscal stimulus if companies would step up business investment in response to lower tax rates, thus raising productivity and potential output growth. While the jury is still out, there are few signs so far that this is happening. Companies seem more inclined to use the tax cuts for stock buybacks, higher dividends and takeovers rather than productivity-enhancing fixed investment.
Tightening monetary policy
Higher inflationary pressures caused by expansionary fiscal policy would also embolden monetary policymakers to push rates higher and higher. Recall that after six quarter-point increases in the federal funds rate to 1.5% to 1.75%, and with inflation on the Federal Reserve’s preferred core personal consumption expenditure (PCE) inflation measure running at about the same rate, the real fed funds rate is already no longer negative and roughly in line with the Fed’s estimate of the current neutral real rate of interest of around zero.
Combined with the Fed’s shrinking balance sheet, U.S. monetary policy is thus no longer expansionary and looks likely to turn restrictive in the balance of this year and next. Obviously, the Fed’s intention would be to prevent overheating and achieve a soft landing of the economy. However, there are very few instances of a soft landing in response to monetary tightening. Rather, unintended consequences in the form of a recession appear to be the norm.
Countering a downturn
The next recession may not be very deep given the lack of big imbalances in the economy, but it could turn out to be more protracted than normal. This is because policymakers will lack adequate tools to stimulate demand. Fiscal policy in the U.S. will probably be constrained by large budget deficits when the next recession hits.
True, the Fed should have rebuilt some ammunition to cut rates and expand the balance sheet again by the time the next recession arrives. However, it appears unlikely that it will have made enough progress to be able to reduce the fed funds rate by the average 400 to 500 basis points seen in past recessions.
To make things worse, other central banks such as the European Central Bank and the Bank of Japan have not yet even started to normalize monetary policy and so would not be able to build much ammunition for the next downturn before it arrives.
A late-cycle economic expansion with lingering inflation pressures and still low near-term but rising medium-term recession risks is tricky to navigate for investors. Volatility will inevitably be higher than in recent years as central banks remove accommodation and the economic outlook becomes more uncertain.
Here are a few things investors should consider in this environment.
First, at current yield levels, U.S. Treasuries are not cheap but should provide some diversification benefits for otherwise risky portfolios in adverse scenarios.
Second, credit spreads start to widen well before equities peak. With credit spreads still tight, investors should consider moving into the safer parts of the credit spectrum and focus on shorter maturities. Also, mortgage-backed securities look more attractive than low-rated corporate credit, reflecting less levered consumer balance sheets and a solid U.S. housing market.
Third, emerging market assets still look attractive given that many economies are early- to mid-cycle and growth drivers have become more domestic, with consumers benefiting from structurally lower inflation. Yet liquidity remains key in this more volatile global environment, which is why we believe it is preferable to gain exposure to emerging markets through a basket of high-yielding local currencies.
As we enter the last, more volatile phase of a long expansion and bull market, liquidity, diversification and flexibility will be key to protect portfolios.
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