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Sustainable Expansion: The Glass is Half Full
By Girard Miller, CFA
Some investors fear that this business cycle is about to turn downward. They fret about weakness in the housing market, worry about Mideast and Korean geopolitical tensions, and note that the Treasury yield curve remains inverted. Despite these legitimate concerns, the economy continues to expand and the markets' tone is positive. This article will explain why the glass is half full, not half empty, and why several years of sustainable economic expansion are now the most likely scenario.
Business cycle basics. First, it is helpful to review how the business cycle works. Each cycle starts at the bottom of a recession from the previous cycle. In the recession phase, excesses of the prior credit cycle are washed out through an economic contraction, a credit squeeze, bankruptcies and lower prices of once-overpriced equity, commodities and property. After an average of 12-18 months of economic misery nationwide, this washout is complete, and the economy typically begins to recover as investors see bargains, enjoy the benefits of cheap capital, and again feel confident that they can take risks.
The catalyst for a cycle bottom is low interest rates and re-liquification of the banking system. During the preceding recession phase, and as the economy bottoms out, the Federal Reserve increasingly pumps liquidity into the banking system and the bond market through open market purchases of government securities, and capital becomes cheap for strong borrowers with high credit quality. Even without central bank action, the bond market would typically rally in recessions and business cycle bottoms. In recessions, long-term investors seek safe havens, low-quality borrowers withdraw, and inflation becomes a secondary concern. Credit becomes cheap and plentiful to the strong who are able to refinance their debt portfolios at lower costs, while cheap money is simply unavailable to the weak. It is essentially Economic Darwinism.
Ultimately, this infusion of cheap credit promotes a new round of prudent risk-taking which allows the economy to first recover and then to expand for several years beyond the recovery phase -- until it again develops excesses in credit, production and consumption that ultimately require another recession to restore a sustainable level of economic activity. Interest rates typically track along with the production cycle, often with a lag, with a few exceptions as noted below. The three phases of a business cycle are therefore: recovery, expansion and recession. (We are now in the expansion phase of this cycle.)
In this business cycle, which bottomed in 2002-03, housing led the markets higher as cheap credit enabled homeowners to refinance and to bid up housing prices. In fact, the initial recovery in 2002-03 was led by housing, as much as the stock market.
Recovery brings tighter markets. During the recovery phase of a business cycle, the economy must first work to regain the production levels of the previous cycle peak. Idle resources are available to put back to work, including both labor and physical plant. Thus, the economy can grow rapidly from depressed levels during the early phases of a business cycle recovery, as there is very little real cost to expand. Throughout a recovery phase the economy simply re-deploys capital that was already in place. Very little new construction of plant and facilities is needed, as idle resources again become productive. During the recovery phase, business capital spending is typically focused on new cost-saving technologies and equipment, rather than new plants and buildings; thus the business demand for capital is minimal. Wages remain stable as there are plenty of workers still unemployed from the last recession. Inflation remains benign, and the Fed typically remains accommodative, to ensure that the expansion becomes self-sustainable. The largest annual percentage gains in the stock market are typically realized during the recovery phase, especially in the earliest years, as stock investors anticipate the eventual turnaround in profits.
Only when the economy begins to reach its former peak level of output do we see markets tighten. At that point, commodity prices typically increase or even spike upward, as demand begins to overtake the available supply -- which was trimmed during the previous downturn. In our current cycle, we saw dramatic increases in oil and commodity prices in 2004-06 as capacity had shrunk during the 2001-02 recession, and the secular expansions in China and India fueled new global demand for now-scarce commodities. Likewise, it is typical for interest rates to shift higher in that middle stage of a business cycle, as the recovery phase is completed and businesses and individuals begin to demand more financing to expand and to spend.
The shift from recovery to expansion is an inflection point, when interest rates play a role in subduing the growth rate that was enjoyed during the recovery phase, to a slower, sustainable rate during the ensuing expansion. Cheap capital gives way to risk-priced capital, as borrowers will readily pay more in interest while lenders will demand a higher rate for fear of inflation in the future. Such interest-rate spikes were particularly prevalent during the 1970s, 1980s and 1990s, when many treasury managers experienced investment losses at the end of each recovery phase. In those earlier cycles, the markets forced a new equilibrium growth rate by pushing rates significantly higher -- not the central bank, which tended to lag the markets.
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Business Cycles Since 1945
(Shaded Areas are Recessions) |
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What's different this time. In the current cycle, the Federal Reserve was able to keep ahead of the markets in gliding the economy from recovery to expansion. The Fed raised interest rates systematically and quite openly over a two-year period. From an historical perspective, the Fed's now-completed tightening cycle is the most successful in modern central bank history. It was transparent, clearly announced, and fully anticipated. In a world of leverage where policy errors in the form of an abrupt tightening could have been disastrous, there were no meltdowns during this period. Although there remains some risk of embedded core inflation that could later spook the markets, the recent correction in oil and industrial commodity prices does suggest that inflation will remain benign in the near future. With the housing market “on the ropes” like a weary prize fighter, much of the speculative froth that worried economists last year has given way to a wary, careful consumer who is unlikely to overload with too much debt. The days of spending from home equity lines of credit and flipping houses to buy luxury goods are now history.
This shift in the drivers of GDP from the consumer and government sectors to the business sector should enable the U.S. economy to shift from rapid-growth recovery in 2003-06 to a slower, sustainable expansion for several more years, perhaps to the end of the decade. Especially if oil prices remain relatively benign in the current price range, the American consumer will be able to afford discretionary purchases, incomes will continue to rise moderately as the labor force nears full employment, and businesses will keep expanding cautiously. Holiday spending in 2006 should be robust, and carry into 2007 even if housing prices slip.
A tortoise expansion. Slower growth is not a bad outcome. In fact, the best path for this economy will be a real GDP growth rate of 2 percent over inflation, which is sustainable for several more years. Unlike the 1990s when new internet technologies inflated the dot-com bubble, this expansion cycle is more of a tortoise. Even so, corporate profits can increase by double digits in such an environment. Returns on equity can average between 12-15 percent for the Fortune 500 especially if capital costs remain at current levels, which permit increased operating leverage. Interest rates may eventually track slowly upward in later years as demand for goods and capital grows, but as long as prices remain relatively stable in the commodity, housing and labor markets, there is little reason to expect that interest rates or a tech-stock bubble will again be the culprit that forces the next recession.
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Interest Rates (1970 to present) |
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Why cycles are longer. This brings us to an important observation. The average life of a business cycle since World War II was less than four years. However, as the American economy has shifted from goods-production to a services orientation, the business cycle now runs longer. In the days of smokestack industries, an economic expansion meant that businesses needed lots of additional capital to build new plants and production facilities, and consumers needed more capital to buy durable goods. Car and appliance dealers had to finance their inventories. This pushed interest rates higher, and at the peak of the cycle it created an inventory of plant and goods that could be cannibalized during the next recession – thus creating volatile cycles as demand shriveled while everybody “made do” with capital goods purchased in the previous expansion. Now that the services sector dominates our economy, the amplitude of the cycle is reduced because consumption is more consistent, and the cycle can run longer because capital is not the constraint to continued growth that it once was.
In 2007-2008, an exogenous shock to the economy, such as a rouge military conflict, a terrorist attack or $100/bbl oil, is much more likely to cause the next recession than would higher interest rates and an inverted yield curve. The extended expansion phase of this cycle will likely continue until something disruptive occurs outside the financial system. Always remember, however, that with each future year of expansion during this decade, we will be playing out the final innings of this cycle, and the economy will ultimately become more fragile and susceptible to such external shocks. By the end of the decade, the financial system may eventually become over-leveraged simply by virtue of time and the accumulation of investments made in this decade, and thus ripe for a correction. Any expansion beyond 2009 should be considered “overtime” and portfolios then should be postured defensively.
Investment strategies. So, in this context, what should public investors do? First, we need to be patient. Let us also remember that few public treasurers have made money by extending maturities in the bond market during the expansion phase of a business cycle. Although there has historically been a profit opportunity to buy bonds mid-cycle as the frothy recovery phase gives way to sustainable expansion and subdued inflation, one must question today whether most of that play has already been captured. In the next two years, capital gains in the bond market are possible only if commodity prices and inflation rates fall dramatically and unexpectedly lower. That seems less likely than an eventual rise in yields as the economy continues to expand at a sustainable pace.
Short-term rates may slide downward if the Fed determines that inflation is dead, but investors should not be surprised to see the curve remain inverted, with shorter-term rates hanging above longer-term rates for some time. The Fed will serve the country best by holding tight to prove its resolve to maintain a stable dollar, which will otherwise erode in value in light of our trade deficit. Likewise, the Fed would be reluctant to invite another round of adjustable-rate mortgage giveaways and renewed speculation in housing, and would be better served if it can keep homeowners feeling a little bit edgy in coming years. Thus, an inverted yield curve is likely to prevail throughout this cycle's expansion phase, and without predicting an imminent recession!
A soft landing in housing and in the financial markets generally is possible if the Fed keeps overnight rates snug but not oppressively tight. That will allow the bond vigilantes to relax, keeping 10 year Treasury bond yields and mortgage rates low enough to permit an orderly migration by consumers out of the now-unaffordable ARMS and under–priced mortgages they swallowed in recent years. The last thing the Fed or the markets need is a mortgage credit scare, with Freddie Mac and Fannie Mae credit quality called into question. Gradualism and rationalization of the mortgage market will therefore be the preferred course for the Fed to pursue, and an inverted yield curve is ideal in this context.
Thus, short-term rates may decline in the future, but there does not appear to be a profitable trade to undertake into longer maturities that yield less today. Capital gains in the bond market remain dubious.
In the higher-yield sectors, credit spreads are very thin, and investors are accepting too much risk for too little additional yield. In times like this, it will pay to sacrifice a little yield and stick to higher quality, especially on notes and bonds with maturities beyond two years. It is far better to wait for a credit panic and a price correction before downgrading your portfolio's quality at this point.
For equity investors, the next year or two could bring a reincarnation of the “Goldilocks markets” of the mid-1990s. Through the 2008 U.S. Presidential election and the 2008 Chinese Olympics, the political environment in both of these powerful nations will remain subtly pro-growth. If these economies can avoid extremes, then businesses worldwide should be able to continue producing record profits as rising employment creates more household income. Capital outlays in the business and commercial sector globally should offset any sluggishness in the U.S. residential housing markets. Corporate balance sheets are in great shape, and if anything, we will likely see an increase in leverage in the next two years, with more buyouts, mergers and acquisitions pushing equity prices higher.
Further double-digit equity returns are certainly a possibility if this scenario holds true, even if markets fluctuate around a general uptrend with occasional periods of weakness and short-term pessimism. As the expansion continues, use a disciplined asset allocation ratio to cap your equity exposure, rebalance frequently, take profits in equities when opportune and re-allocate regularly and at least annually. Do not be tempted to “run the table” and ride profits to the ever-elusive market top, as people tried in the late 1990s. There will be a recession someday, even though it is likely to be several years from now, after more excesses are built into the economy. And when a recession occurs, it is likely that equity prices at the bottom tail-end of this cycle will be lower than those in December 2007 or 2008.
International investments still deserve a place in a long-term portfolio, as the risk of a dollar slump will never leave us. Growth overseas, especially in Asia, is likely to outpace America's. Japan is back on its feet and should enjoy a simultaneous expansion. But for the next two years, U.S. multinational large-cap growth stocks appear well poised to perform at or above the rest of the global markets generally. Thus, there is no need to overweight foreign stocks now, and the international bond market offers no great bargains. In fact, emerging market debt is too rich; spreads are narrow and unattractive in light of potential risks that occasionally flare in these markets and take investors by surprise. Less-regulated debt markets overseas could be the first to crack in the ongoing synchronized global economic expansion that we now enjoy.
Those striving to think truly long-term will begin planning their strategy to have some powder dry in the next recession. That can be achieved by directing profits earned in the coming two to three years to high-quality bonds at yields above those available today. Moving all (aggregate) appreciation out of one's core equity position at the end of each of the coming years is a scale-out strategy worth considering, both for individual retirement investors and for pension trustees.
For example, a classically normal 60-65 percent equity portfolio should salt away its equity profits annually during the next three years, until an extra 10-15 percent of the portfolio is held tactically in a temporary reserve of additional bonds or cash (plus the normal allocation) to weather the next bear market. If the stock market generates double-digit returns during this period, the actual dollar value of the core stock position should remain fairly constant under this strategy while the equity percentage declines toward 50 percent at the end of the Expansion phase. The “harvested” profits in the final innings can then be redeployed in riskier securities at bargain prices at the bottom of the next recession. Even if some additional profits are foregone in the final years of the expansion, and this money misses the top of the market, there is good reason to believe that this “creaming” or “dry powder” strategy for the late Expansion phase of the cycle will outperform a traditional buy-and-hold approach, and with far greater peace of mind.
For Treasury managers, a companion strategy based on cycle tactics would be to gradually extend maturities and portfolio duration after the economy has expanded another year or two, especially if long-term rates have increased by then, as typically occurs when the champagne glasses of equity investors look 90 percent full. Bonds are not a bargain now; why not wait until they are so again?
Girard Miller, CFA, the founding editor of Public Investor, is an independent investor and investment commentator residing in Malibu, California. His investment opinions are his own and are not intended to constitute specific investment advice. After December 8, he can be reached at girardmiller@gmail.com.
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