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12 Jul 2020

It's the start of a new economic cycle. What now?

By Steven Weiting, David Bailin & Simson Sanaphay COVID-19 catapulted us into a new economic cycle, and already it's looking different.

This is a brand new economic cycle. It is beginning with a brief, extremely deep, rolling global recession, which is likely to be followed by an initial, sharp snapback in global economic activity that will achieve only a partial, uneven recovery.

We then expect a slow expansion that will take us back to 2019 levels of corporate profitability by 2022.

Volatility will remain a frequently visited wildcard for the remainder of the year. Globally, COVID-19 has yet to be contained, and it will continue to impact economies and communities.

Undeniably, the new economic cycle is starting with significant difference to what we may normally expect. The end of the ‘boom’ did not have the euphoric frantic activity typically associated with the close of a cycle, and as you can see in the clock below, we certainly have not commenced the new cycle with rising interest rates.

We will look at two clocks. The first is a typical investment clock for equity markets. The arrow in this case has no significance. But as you can see, as we start a new economic cycle we should have rising interest rates. That is certainly not the case, and is a result of unprecedented government and regulatory intervention across the globe to combat recent year's economic headwinds.

Economic turmoil has pushed this clock out-of-synch

 
Source: Bourse Communications

Its fair to say the investment clock, which has been a good predictor of forward  indicators for over 50 years, is out-of-synch with the current environment, and likely will be for at least the remainder of the year and probably the next.

We have adjusted the clock and added in credit markets, to make it a broader guide of investment cycles with current economic data. It's important to note central bank intervention and government policy has effectively led to a bypass of Phase one (F1).

A new investment clock for a new economic environment

Source: Citi Research

Where are we now

The temporary global shutdown and the path to recovery from the pandemic have altered the dynamics of the global economy in material ways. Certain industries, such as technology, are permanent beneficiaries. Other sectors, like traditional retailing, are permanent victims.

Large companies will, by and large, weather the storm better than small ones. Developed nations with more economic and natural resources will fare better than less developed countries. And there will be millions of small and medium-sized businesses that fail.

The virus will affect every individual and every business in ways that are uneven and sometimes unfair, with winners and losers standing side by side in stark contrast to one another. The world’s stock markets have rapidly reflected this, with highly divergent valuations in equities of resilient firms and those in significantly impacted industries.

Dealing with low interest rates

The most material issue for investors over the next five years will be low rates. With the yield on US Treasuries falling closer to zero, asset allocations will have to change materially.

Historically, fixed income zigged when equities zagged. Their negative correlation served as a natural hedge. That is no longer true.  Then there is the associated issue of long term returns. If fixed income cannot provide reasonable returns and as much diversification, portfolios should reflect such realities.

Staying diversified & the role of currency

It means diversification remains paramount to ensuring portfolios resilience to future volatility.

While most portfolios will hopefully contain the basics - equities, bonds, property and cash. Another class to consider is currency.

In times of uncertainty money flows to safe haven currencies, like US dollars and Japanese yen, making these currencies appreciate and keeping them strong.

This creates opportunity to purchase US assets, like investment-grade bonds, in US dollars and seek a currency benefit to boost your overall return, as well benefiting through geographical diversification.

It also widens your investment universe, opening up opportunities in global sectors like pharmaceuticals and technology that are not available in Australia.

Major sources of risk

The major “risk” currently impacting markets is COVID-19. And that is because the pandemic is not at its end. Looking at US data, fatalities reached 130,000 in early July, and across many states virus infection rates were still accelerating.

Only when infection rates (Ro) fall sustainably to 0.5 or less, may the end of the pandemic be in sight. This means that COVID-19 will remain prevalent globally for a year or two or longer, unless a vaccine is found and broadly distributed. The economic friction associated with living and working through a pandemic across a modern economy has never been experienced or modeled.

Until a vaccine is found, the global economy will not fully normalise, and health frictions will dampen economic activity overall. When a vaccine is found, there will be a rapid path to a “new normal,” as well as a further acceleration of economic activity in industries and companies that are strategically and financially well positioned.

Of course the virus is not the only major risk in the market. China-US relations and the threat of the resumption of escalating trade wars remains an issue that is unlikely to be resolved this year.

  • Investors can reduce portfolio volatility simply by holding assets in safe haven currencies like USD or JPY. As risk increases, or an event causes a flight to safety, these currencies will likely appreciate while equity markets will fall, and offset part of the loss in equity.
  • For example: During the global financial crisis the USD gained by 43 per cent against the AUD when equities fell by 51 per cent. Investors who held 50 per cent of their portfolio in US dollars only had a loss of 8 per cent, compared to 51 per cent for those who didn’t diversify into a safe haven currency.

Remaining clear eyed

Although it seems almost inappropriate to talk about prosperity, profits and opportunity as a result of the pandemic – this is a resilient world. To earn above-average returns, you have to make calls on what to buy and when. Great investments often arise at times of great dislocation, and even discomfort.

  • It means considering out-of-favor markets and those industrial groups, including airlines, which are under extraordinary stress but must come back in order for the global economy to heal again.
  • But it does not mean throwing caution to the wind. There is time to be thoughtful, and to validate strategies.
  • Although many will chase market rallies, we expect global equity returns to be limited and shares to be near current levels 12 months from now.

There are some things we are certain about. We know the global economy will fully recover, but not the exact timing. And we know that innovation, invention, and ingenuity will continue to power changes, and that leaders in such endeavors will be well rewarded. And we also know that darker days give way to lighter ones.

Steven is chief investment strategist and chief economist for Citi

David is chief investment officer for Citi

Simson is chief investment strategist for Citi Australia's wealth management business

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