Our Insights

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September 4, 2014

Are we closer to the beginning or to the end?

Investors who have lived through the traumatic experience of 2008 are often prone to seeing another crisis just around the next corner. That’s called recency bias. We are inclined to use our recent experience as the baseline for what will happen in the future. In many situations, this bias works just fine, but when it comes to investing it can cause problems. The media tends to exacerbate this problem because bad news just sell better. So what to make of recent articles in the media that this recovery is already long in the tooth and we are doomed for another bust?

The facts on the grounds do not support the view that this recovery is ending anytime soon. All the key economic indicators are actually pointing to an ongoing, albeit slow, recovery. Let’s look at some of the key data.

At the end of every business cyclce we typically find companies increasing leverage again. This makes their balance sheet riskier and more vulnerable to any kind of slowdown which then turns into a cyclical bust. Today the major economic regions in the US, Europe and Japan are all showing a record low debt-to-equity ratio.

JPM Corporates in US EU Japan have all reduced gearing

The state of corporate balance sheets clearly remains robust. They do not show signs of euphoria or excessive leverage. In addition, cash on corporate balance sheets remains at record highs. If we look at the companies in the MSCI Europe (same trend for US and Japan), we can see unprecedented amounts of liquidity. This cycle has more room to go because corporates are not in a weak position where they might need to retrench – quite the contrary.

JPM MSCI Europe cash on balance sheet

What about the largest economy, the US? The expansion that began in July 2009 is now 5 years old, similar to the average post-war recovery. Many commentators have taken this as a sign that therefore the US expansion must surely be coming to the end. However, no business cycle is ever the same and this expansion is very different because of the depth of the recession in 2009 and the slow recovery thereafter. In fact, today’s US expansion has only early-cycle to mid-cycle characteristics.

GS Spider early stage characteristics of US expansion

Another key driver for the business cycle are commodity prices. We now easily forget, that the outbreak of the credit crisis was preceded by rapidly rising oil prices which reached an all-time high of nearly $150 per barrel in July 2008. This weighed heavily on consumer demand and company margins. Today the picture looks completely different with all the major commodities in energy, metals and food showing declining prices for more than 1 year.
BNP Econ studie - commodity prices falling - graphic

Investment implications
So far we have only written about the real economy which can move in different cycles to the financial markets. However, the scenario we have outlined here has several implications for investors:

  • Corporate bonds: a sudden spike in the default rate seems unlikey today
  • Equities: the corollary of the robust balance sheets is that currently elevated P/E multiples might end up being more sustainable as the capital structure underpinning the equity portion is stronger. Equally, management has room to engage in more shareholder friendly policies such as share buybacks.

So no 2008, but what about 1987?
The outlook we presented here is clearly not good news for investors who have missed the rally in the last 5 years and who are looking for much lower entry-levels. We think a re-run of the 2008 crisis is unlikely in the short-term. However, what we can never rule out, is a replay of 1987, i.e. a correction. That correction wasn’t really related to the broader economy. We are actually quite bullish about companies and different sectors, but we are bearish about liquidity because we are moving into a tightening environment. We think liquidity (or lack thereof) could be the next trigger for a correction. The market to watch is the credit market, where this problem is most likely to manifest itself first.

Since nobody has ever been able to reliable predict the timing of corrections, we will refrain from doing so. Instead, what investors need to do today is to set up a plan that helps them to step in and buy whenever the next opportunity arises.

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