Late-cycle investing: when and where?
The risk is that monetary easing may over-stimulate the US economy, already at full employment, resulting in a sharp tightening in financial conditions leading to a recession. Investors should consider gradually reducing exposure to global equity markets and within the equity category consider moving exposure away from high growth investments towards more quality and value-based investments or managers.
Some cash on hand will likely reduce the volatility of your portfolio, while providing the opportunity to buy cheap assets in the event of a market sell off. In the absence of the protection historically provided by bonds, investing with good hedge fund managers is likely to pay off as the increased market dispersion should be beneficial to these managers.
In the late part of the economic cycle, inflation often starts coming through as the economy starts to overheat and there aren’t enough resources available for the increased demand - be that commodities or labour. As a result, in addition to equities, real assets that can offer protection against inflation tend to do well in this environment.
As inflation rises, however, interest rates are also likely to rise as lenders need compensation for the decline in purchasing power of future interest and principal repayments. Therefore bonds, notably fixed rate bonds, are negatively impacted by inflation as yields rise and therefore prices decrease.
The longer-dated the income stream, the more negatively the asset will be impacted as the income stream is being discounted for a longer period. For example, a 1percent interest rate rise will have a much larger impact on a 100-year bond than a two-year bond.
Similarly, if you’re invested in companies where you’re paying a high price for future earnings growth in 10 or 15 years’ time, those earnings will be discounted more aggressively. So, as interest rates rise and the economic outlook becomes more uncertain, the valuations of high growth companies will tend to be more negatively affected than, for example, well run companies with a strong asset underpin. This is the part of the cycle where value and quality stocks generally outperform high growth stocks.
As the economy turns down there is generally increased dispersion in returns, both between and within asset classes. Since the global financial crisis, momentum has been the order of the day - assets have risen and fallen together largely driven by monetary conditions.
As a result, investors haven’t been as discerning about their assets. A momentum driven environment is difficult for active managers, which is why there has been such a big move towards indexation, or passive investing. This changes as the economy slows and poorer quality assets start to show their true colours.
Bryn Hatty is chief investment officer of Stonehage Fleming South Africa.