Navigating the Autumn of the Business Cycle

"Opportunities for 2019: Identifying Trends" was the leitmotif at the discussions on the occasion of the celebration of the 90th anniversary of "Finanz und Wirtschaft" at the Tamedia quarters in Zurich.

History of capital markets is replete with bubbles, investors misidentifying trends and entering the market too early or too late. While investors are enjoying the longest boom in history, also this one will inevitably come to an end and as inevitably will be followed by a recovery. The critical question for an investor remains: when and how will the downturn happen, and how to navigate the rough waters best? Is there a strategy that would brace investors well for both the short and the long run?

In perfect markets, the recommended long-term strategy, and not only in textbooks, is buy-and-hold. However, our markets can hardly be called "perfect" with crucial players being external to the game in the capital markets, notably, the central banks and the powerful regulators.

Thorsten Hens, professor of financial economics at the University of Zurich, demonstrated a score chart for numerous strategies across historical bubbles with no strategy that would perform best in all business cycles. In his favourite "Doppler" strategy, one invests the amount "x" and waits until "x" doubles. Once "x" has doubled, one half of the doubled "x" is saved and the other half is invested again, and so on. This strategy, even though not the best performing one across all historical business cycles, played out well for him due to minimization of regret. The crucial point, according to Hens, is identifying one's risk tolerance at the outset and consistently following a selected strategy.

It is high time for defensive stocks
In the late stage of the current cycle there are justifiable anxieties as to how imminent the next bubble bursting might be. In spite of wide spread concerns about the unprecedented sovereign debt, persistently low interest rates, political uncertainties and the on-going trade debates, it seems that markets have been given some slack – likely well into 2019. Therefore, no talk should be about a ticking bomb but about the still available opportunities instead.

As cumbersome as accurately predicting the end of any boom might be, paraphrasing Ben Bernanke, Anastassios Frangulidis (Pictet Asset Management) claims that a cycle ends when the central bank ends it. In the meantime, Frangulidis recommends defensive stocks that offer more stability – a recurring theme throughout the evening. Members of the FuW panel, on the other hand, discussed the merits of investing in companies that correctly identify structural trends in demand and have a well thought-out focus or in equities of well diversified staple producing corporates like Nestle.

The US trade disputes, especially with China, and its lamentable protectionist ramifications in the long run were recognised as a potential accelerator to end the past decade's capital market party. However, Trump's infrastructure spending would, according to Chris Schenk (ZKB), offer promising returns on equities of US companies benefiting from President Trump's Keynesian expenditures. Further recommendations emphasised the virtues of companies in the real economy.

Amidst general bond bashing, it has been agreed upon that there is not much growth potential in bonds, other than the robust productivity growth in the economy at large, but with a caveat that one need to be mindful of demographics. Equities in selected sectors have been the evening's favourite. In the transition times from liquidity-driven to profit-driven capital markets, it is the companies with not too highly leveraged balance sheet, companies with a strategy reflecting longer term trends, and companies with a successful turnaround that draw stock pickers' keen eye. While the big international corporations have been among the initial winners of globalisation, it is the agile mid-sized ones that surface later on in the highly competitive global game, among them some Swiss pearls.

A degree of flexibility for the FED
If 2017 was an exceptional year on the account of its extremely low volatility and extraordinary liquidity - the volatility in 2018 has been also relatively low by historical standards, the profit dynamics for the rest of 2018 expected to be lower than originally predicted with expectations still lower for 2019.

While the Fed – considering, inter alia, the current yields crossing the 3% watermark, consecutive rate hikes in 2018 and 2019 – will have a degree of flexibility, should inflation kick in, its European counterpart will not enjoy such a favourable position. With its current interest rates at zero and below, Italy – a ticking bomb with its GNP a multiple of Greece (the latter far from being out of the woods), big question mark surrounding Brexit, mounting debt and Mario Draghi still at the printing press, the ECB will be ill positioned to counteract inflationary pressures.

China's immense private and corporate debt
The cautiously optimistic picture of the world economy with good prospects hasn't been everybody's cup of tea. The wake-up call came from Felix Zulauf – a personality in the Swiss financial community.

The ubiquitous shift towards populist sentiments and ensuing protectionism with its unintended long run consequence of everybody's economy shrinking can be attributed to the uneven distribution of gains and losses across countries and especially within developed economies. In the latter the bottom and the middle classes have largely missed the bandwagon of economic growth; the liberal political elites' ignoring growing popular discontent.

In the meantime, China has been ascending to the status of the world's economic powerhouse, even if its GNP still lags behind the US'. Zulauf's careful peek under the surface of the popular data reveals a picture that should raise deep concerns. Aside from the political ramifications, one is to realise that it is China's sneezing that causes serious flue in the rest of the world.

It is China's immense corporate and private debt, exceeding the countryss GDP by a factor of three, government sponsored misallocation of capital investments and the likely change in China's infrastructure investment policy that should be sending chills down the spine of companies outside of China.

Who should worry most about China's slow-down
With China's growth rate slowing down to 3% (Zulauf's projection) companies, whose growth and sometimes existence hinge on China's economy booming, will suffer the most. This is especially true for the ones counting on the unwavering support of the Chinese government for the investment rate currently running at unsustainable 42% of GNP, while both investment and consumption growth remain highly leveraged (at 20% in Zulauf's estimates). With private company debt amounting to USD 3bn, in order to avoid credit crunch, PBoC would need to engage in aggressive QE, thus, weakening its currency.

To offset capital outflows, the government has already instituted capital controls, the real estate markets in London, Paris and New York feeling the consequences. When China slows down, various economies will suffer to a different degree. For Switzerland and Germany, with 10% exports to China each, the impact will be felt.

Come rain or shine, the world will go on…
According to Zulauf, the Fed will increase liquidity only in case of an abnormal event. Hence, for the time being, rate hikes shall proceed as expected and the dollar strengthen against all currencies. This is bad news for the heavily in dollar indebted emerging markets. When the end of the bull market arrives, the Fed will reverse its monetary policy and in the long run we will have a new bull market da capo. Life – in the long run – will go on, as it always has.

If Zulauf's numbers speak the truth and the world will turn the way he predicts, the tables may even turn earlier. The sure thing is that there will again be a substantial redistribution of wealth. For the time being the Goldilocks world continues, maybe with one coffee a day or one vacation less on the agenda.