Is the longest US business cycle on record under threat?

Most of our landed estate and farming clients look to diversify their asset base into different asset classes where possible, including the stock market. Many have portfolios with Smith & Williamson Investment Management LLP.

Those with exposure to the markets will have been monitoring the political and economic climate in America which remains the world’s largest economy and a key driver of global markets. Apart from Independence Day and the 50th anniversary of the moon landing, the US had another good reason to celebrate July. The month also marked the 11th year of economic expansion and set a new record for the longest business cycle from data going back to 1854. Given the length of the current expansion, there are doubts that it can continue. However, it is worth noting that the expansion has been quite tepid; the current average annualised real GDP growth of 2.2% since 2009 is the lowest rate out of all the post-second world war recoveries*. For investors, the slower pace of expansion should be seen as a positive, since it probably means that there is less likelihood of accumulated economic imbalances (e.g. rapid credit growth) to undermine the business cycle. Moreover, a paper released by the Federal Reserve Bank of Cleveland in February makes the point that there is no evidence that long expansions are necessarily followed by deeper recessions.

The bottom line is that so long as the US economy is growing, corporate sales can continue to increase to provide fundamental earnings support for US (and global) equities. On top of company earnings, shareholder returns have also been boosted by around $5trn in equity buy-backs since the bull market started in 2009**. US equity valuations look justifiable provided global growth continues to expand, as we expect.

While the US economy does continue to expand, there are growing concerns over signs of a slowdown in the global economy which has prompted dovish messages from the US, UK and European central banks, all of which are expected to keep interest rates lower for longer. Global government bond yields reflect this uncertainty with US, UK and German 10-year government bond yields trading near or at record lows. In addition, the nomination of Christine Lagarde as the next president of the ECB also helped to lower yields. As a continuity candidate, Ms. Lagarde has strongly backed ECB President Draghi’s “whatever it takes” pledge in 2012 to use unconventional monetary policy (i.e. quantitative easing) to support the euro and has recently called on central banks to adjust policies in response to concerns about global growth. We see three key risks from bonds that could spill over to equities.

First, would be a US inflationary surprise that forces the Fed to become more hawkish on interest rates. Bond markets would likely correct and this could undermine the rally seen in equities.

Second, in a desperate search for yield, investors have been willing to take on more risk than they perhaps realise. For instance, even though Italy has a huge public debt pile and the current Eurosceptic administration has a fractious relationship with Brussels, the Italian government was still able to issue a 50-year bond that was 6 times oversubscribed at yield of 2.9%, almost a full percentage point down on late 2018. Should the Italian political relationship with the EU deteriorate, it could lead to a contagion sell-off in riskier forms of debt.

And third, considering that the prices of fixed income and equities have been tightly correlated, so that both asset classes have risen this year, a sharp unwinding of extremely overbought bond positions could have a detrimental impact on equities.

Provided global growth stabilises, as we expect, this will provide a favourable backdrop for company earnings and some protection for risks in the bond market. On balance, we remain constructive on equities over bonds as an asset class but would champion a well-diversified portfolio with an appropriate asset allocation, depending on an investor’s ability and willingness to take risk.

Smith & Williamson is a leading financial and professional services group providing a comprehensive range of investment management, tax, financial advisory and accountancy services to private clients and their business interests. The firm’s c1,800 people operate from a network of 12 offices: London, Belfast, Birmingham, Bristol, Cheltenham, Dublin (City and Sandyford), Glasgow, Guildford, Jersey, Salisbury and Southampton.

We have more than 170 investment managers, diligently catering for our clients’ individual requirements. We have around £20.8 billion of funds under management and advice, the majority for private clients, as at 31 March 2019.

We have been recognised by various industry experts, judging panels and awarding bodies for our investment performance and client service. We are proud of these achievements, including PAM Awards 2019 & 2018 – Winner – Investment Performance – Defensive Portfolios; Citywire Wealth Manager, Investment Performance Awards 2017 - Winner - Best Overall Large Firm; Citywealth Magic Circle Awards 2017 - Winner - Best Private Wealth Manager, 2018 Spears Award for Family Office Services.

Past performance is not a guide to future performance. Capital at Risk. The value of investments and the income from them can fall as well as rise and you may not receive back the original amount invested.

Sources

*Datastream, correct at 9 July 2019.

**Sean Darby of Jefferies, correct at 9 July 2019

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By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

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