Why are we late cycle? The usual profits cycle/inflationary pressures stories are valid but the events of the summer also have a bearing on the debate. Property values and growth expectations underpin or collateralise the debt that fuels economic growth. It looks increasingly like property prices have peaked and may even fall in some parts of the world. That leaves growth expectations as the primary underpinning of the debt burden and that makes the expansion more precarious.
What happens if more serious, broader-based fears set in regarding the value of property? What happens if doubts arise about the durability of growth? What happens, we think, is that someone raises a big fat sign saying: “The end.”
But what happens in the meantime? Property is no longer working as an asset class, with prices falling in the US residential and UK commercial markets. Credit may bounce following the sell-off in the summer but it too is broadly no longer working.
Government bond yields are already pretty low, assuming that recession is avoided. Does it not seem, therefore, that if growth holds up, then equity markets are the only place to be?
So, in terms of the outlook for the fourth quarter of 2007, we suspect the path of least resistance for the equity markets is up. The US results season should be OK, with international companies driving the upside surprise stories while domestic earners are likely to provide the bad news on the downside.
We think the reports will be good enough and maybe even have the right character to maintain growth expectations. Of course, we are late in the cycle and currency-aided earnings growth is always low quality growth but investors are often inclined to take things at face value at this stage of the game and we suspect they will do so this time. If we are right on the Q3 earnings season, then it is also right to expect something of a momentum-driven market where good news is rewarded and bad news punished.
Bill McQuaker is head of multi-manager at Henderson Global Investors