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May 2, 2014

Why this business cycle is highly unusual (and could last much longer than you think)

A typical business cycle lasts around 5-6 years. With the last recession ending in 2009, the Cassandras are warning again about impending doom and gloom. We however think that this business cycle in the US could outlast even optimistic scenarios.

The business cycle looks as follows:

What sets this business cycle apart from others in the past is first the depth of the recession in 2008/9 and then the very slow recovery. As a result, the usual signs of a late recovery in year 5 such as rising inflationary pressures, high investments and full employment are completely missing this time. Actually, we have only started to see since mid-2013 signs of a real recovery such as accelerating bank loan growth and rising wages – both datapoints, that tend to occur much earlier in a typical business cycle.

The main reason why we believe that the US economy still has many years of growth ahead is the unusually low investment rate today, which is more typical of a severe recession than a recovery. In order to return to a normal level of investment of around 18% (non-residential and residential fixed investments as a percentage of GDP), it would take at least another 4-5 years based on historical experience. 19% were not unusual in the past either, which could extend the cycle by another 1-2 years.

Cassandras and prophets of doom usually get all the headlines. However, those same people have warned about impending doom and gloom every year since 2009 – and we did not experience a recession! Since the end of WWII, the US never had a recession that started with an investment rate of 15% or below (which is where we are right now). The same reason why it is nearly impossible to have a recession today (barring external shocks) is also the same reason why the US recovery felt so weak since 2009: there was no strong investment growth. However, we have now reached the point where companies need to invest in new capacity in order to capture the additional revenue dollar. As a result, investors are probably well advised to ignore the recession calls today.

Comparing the investment rate today with the capacity utilisation rate highlights several key issues:

  • Since 2009, capacity utilisation (red line) grew much faster than the investment rate (blue line)
  • This explains the strong profit growth. However, profit growth is likey to slow down as companies have to start investing more.
  • Periods like the early 90s which have also seen capacity utilisation outpacing investments were usually followed by a long catch-up phase with strong investment growth.

What does it all mean for investors? It is critical to realize that what we try to describe here is our outlook for the US business cycle – but market cycles and business cycles are rarely 100% in sync. Still, there are a few important take-aways:

  1. Share prices will always be volatile, but if you are hoping for a crash (>20% decline) in order to get in again on the cheap, you might be out of luck. This sort of share price drop usually only occurs during a recession.
  2. We expect volatility to pick up. Not so much as a result of the business cycle but because the US central bank is likely to normalize its monetary policy in the years ahead.
  3. Capex-related industries should become a focus for investors going forward
  4. Corporate bonds appear pretty expensive at the moment, but we do not see a rapid rise in the default rate over the foreseeable future. In this environment, CCC-rated bonds are more attractive on a risk-adjusted basis than BBB-bonds.
  5. The yield of Baa (Moodys) / BBB (S&P) -rated corporate bonds in the US is around 4.9% currently. That is about 160bps lower than 2005 and 260bps lower than 1995. In our view, this makes equities more attractive than credit.
  6. The US equity market (S&P 500) is trading currently on roughly 16x 2014e P/E. This is comparable to 1995 and 2005 – both years that can hardly be described as bubblicious or that were at the end of a bull-market. The only caveat is that the current profitability is much higher than it was in 1995 or 2005 and as believers in mean-reversion (capitalism works as excess returns get competed away) we therefore expect future 5-7y returns to be lower than what we saw previously. This shouldn’t come as a no surprise since 10y US treasuries are yielding only 2.6% at the moment and the market would not be rational if equities would deliver 8-10% p.a. returns in that environment (a normal equity risk premium is typically in the range of 2-4%). Going forward we expect US equity market returns to be around 5%.
  7. Just because we expect the US economy will continue to grow doesn’t mean it will be easy to earn good returns.  Quantitative easing and low interest rates have driven prices up of ALL asset classes thus pulling future returns forward. Investors need to be aware that they are now at a point in the valuation cycle that is at least moderately aggressive.

Ironically, the biggest risk for investors is a stronger than expected US economy which would lead to interest rates increases that are bigger than currently forecasted by the market. Investors need to make sure that their portfolio displays a lower correlation to interest rates than in the past (hint: large caps > small caps, value > growth, international > domestic).

For further questions, please contact us at info@ipanema-capital.com

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