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Preparing for the Next Downturn

Updated: May 18, 2022

From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.

The whole point of a fund is to pool investments and thus diversify risks. Multi-asset funds particularly embody the concept of diversification, because, unlike single-asset class funds, they diversify risks across asset classes as well as holdings. Seneca only manages multi-asset funds, so, with respect to tactical asset allocation, correctly anticipating downturns is critical, enabling us to strengthen our funds’ defences. Bear markets, after all, are when asset allocators earn their spurs.

"Automation has reached a tipping point such that labour no longer has the pricing power of days gone by"

I am anticipating a global economic downturn in or around 2020. This, I think, would precipitate a global equity bear market, beginning some time in 2019. I might be early, but that’s better than late.

Downturns and bear markets are as inevitable as death and taxes, so I doubt that this time is any different. Over the last year or so we have already been reducing our funds’ equity weights as markets have risen. We will continue to reduce them over the next two years such that by the onset of the next bear market our funds are defensively positioned (like driving, slowing down when you get to a bend rather than well before it is, frankly, nuts.)

The current growth phase that began in 2009 is now eight years old. This by most standards should be considered ancient – according to the NBER (National Bureau of Economic Research), the average length of the 11 growth phases in the US since 1945 was 59 months, a little under five years 1(note: does not include the current cycle).

So, why do I expect the current expansion to reach the grand old age of 11, more than double its life expectancy?

The growth phase of any business cycle is itself made up of three sub-phases: ‘recovery’, ‘expansion’ and ‘peak’. The recovery phase is when economic indicators are rising but remaining below trend; expansion phase when rising and above; and peak phase when falling and above (the other sub-phase of the cycle is ‘recession’, when indicators are both falling and below trend). It is during the expansion phase that monetary policy gets tightened, as central banks seek to restrain growth and inflation, and the peak phase begins when monetary policy has become tight and is starting to impact growth.

So, since in much of the developed world monetary policy tightening has yet to begin, we are arguably still in the recovery phase (the US is probably in expansion phase but only just). If that’s the case, a global downturn is far from being imminent.

The current cycle has been characterised by weak inflation. This is despite unemployment across the developed world falling to levels which in the past would have been inflationary (to put this into more technical language, the Phillips Curve has shifted to the left). It is my belief that there are two key reasons for this, one structural and one cyclical. The structural reason is that automation has reached a tipping point such that labour no longer has the pricing power of days gone by. As for the cyclical reason, there may be more slack in labour markets than the headline unemployment rates suggest.

In the US, for example, the participation rate has hardly risen, as might be expected during a growth phase. Some of this is no doubt due to demographics, but then the increasing need for retirees to continue working should render this moot. The large number of disaffected workers who left the workforce following the Great Recession and retirees who need to work should keep a lid on wage pressures for a while longer.

In the UK, the rise in employment this cycle has to a greater extent been in lower paid jobs than might have been the case in previous cycles. Plus, we have the same issue with retirees increasingly needing to continue working. Let’s face it, the gap between retirement age and life expectancy has reached unsustainable levels. Not just in the UK but, in much of the developed world.

These cyclical issues have shown up in terms of weak productivity growth. In the UK, productivity growth has at no point risen above 2% during this cycle, while in previous cycles it has hit 4%. A similar pattern can be seen in the US. Thus there is scope for a cyclically-driven rise in productivity to hold back inflation pressures for a little while longer.

Another simple point to note is that because unemployment rates rose to high levels in 2009, they subsequently had a long way to fall. Naturally, this was always going to take more time than normal. The worse the accident, the worse the injuries, and the longer the recovery time. 2009 was, in no uncertain terms, a car wreck.

So, extrapolating current trends in unemployment rates, and taking account of the aforementioned shift in the Phillips curve which should have the effect of extending the current cycle, I get to a downturn in 2020 (see chart). There is not a great deal of science behind this prediction. It is based on what is essentially simple analysis. But to paraphrase Warren Buffett, simple behaviour is more effective than complex behaviour. And let’s face it, the dismal anticipation by most economists of the Great Recession should have proved once and for all that their trade is not a science.

Published in Investment Letter, July 2017

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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