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Investment Insight: Can we predict today’s economic cycles?

Economic relationships change, meaning that predictions can often prove wrong

Much of Europe has enjoyed an unusually warm summer. But as the nights draw in and leaves turn brown, winter is somewhere around the corner. Like summers, economic expansions do not last forever. As the US expansion approaches its 10th birthday, investors may wonder how much longer it has to run.

While no two recessions are exactly the same, the playbook often runs as follows: unemployment falls; emboldened workers ask for higher pay; central banks hike rates to stem inflationary pressure; higher wages and rising interest costs squeeze profits, which leads to job shedding. Fearful of losing work, consumers rein in spending, demand falls and the recession takes hold.

This looks simple, so why are economists so notoriously bad at forecasting recessions?

Will value trump growth investing in the end?

The reason is that economic relationships can change. Workers may not ask for more pay. Central banks may not slam on the brakes. And households and firms may keep spending despite higher interest rates if animal spirits are running high.

All of these can extend the economic cycle. And, of course, the playbook might change entirely in the event of a financial crisis or geopolitical shock.

It is hard to say where we sit in the current US economic cycle. The unemployment rate (at an almost 50-year low) suggests the expansion is in its twilight years.

However, a rise in productivity indicates that firms are managing to squeeze more out of their existing staff. And with wage growth remaining subdued, there has not yet been a squeeze on corporate profits. Even stripping out the effect of the corporate tax reduction, earnings for S&P 500 companies rose at a solid double-digit rate in the second quarter.

But the Federal Reserve is slowly lifting interest rates. This will be an increasing burden – particularly for the companies that have leveraged up in recent years.

Higher interest rates may well start to bite just at the time when the almighty fiscal stimulus begins to fade.

The European economic cycle is less advanced. Having “double-dipped” with the sovereign crisis, unemployment is still relatively high in much of the region. There is ample spare capacity, which is keeping core inflation low.

In the UK, the recovery was more aligned to that of the US until the uncertainty surrounding the Brexit referendum slowed the pace of activity.

Although these economic cycles are not aligned, it seems likely that a downturn in the US would filter through to a global slowdown.

While it is hard to pinpoint the start date of the next recession, we can say with more conviction that the next equity market contraction is likely to be less severe than the close to 50 per cent corrections seen in the last two recessions.

With the US economy still booming and valuations looking reasonable, it is not obvious that any dramatic shift in portfolio allocation is required. Investors looking to time the market have rarely been rewarded for their efforts. But it seems wise to consider what assets can be added to a portfolio to increase resilience.

In times past, those looking to add ballast might have reached for a higher allocation to government bonds. The difficulty this time around is that interest rates in much of the developed world are still near record lows.

The US government bond market does offer some protection given rates have now risen. But it is much less obvious where investors can find cover in European government bond markets.

Investors should also be mindful of the potential risks in some other areas of fixed income. Corporate leverage has increased substantially and almost half of the US investment grade index is now comprised of the lowest eligible grade (BBB) of bonds.

While there are few signs that either the US or global economy are about to fall into recession, it is good to be prepared. Though traditionally government bonds were considered the first line of defence, we question whether they will prove quite so useful this time around given there is limited scope for interest rates to be cut, particularly in Europe.

Investors should be mindful about how they can dynamically use fixed income and liquidity products, how they may wish to alter the equity styles within their portfolios, and whether alternative strategies such as macro funds or equity long-short funds will serve as a better cushion in the coming years.

Karen Ward is chief market strategist for EMEA at JPMorgan Asset Management

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