Food for thought from the Fed
The most important asset allocation decisions for global investors ought to originate by answering a seemingly simple question: Where in the cycle are we? The answer will largely determine how portfolios balance exposure to risky assets and rates or risk off assets. In this context, it is paramount to define what exactly it means to be in early, mid and late cycle and then assess which one of those definitions aligns most closely to the current economic situation.
The early cycle phase is characterised by a bounce in growth from recessionary levels to above trend output, with loose monetary and fiscal policies supporting an economy's acceleration. In addition, during the early phase of a cycle, companies attempt to improve their credit metrics, particularly those at the bottom of the ratings spectrum. In mid cycle, economic growth is typically still robust but starts to slow from its peak. Governments and central banks begin to rein in stimulus, and companies are rewarded for their efforts, as evidenced by an improving ratio of rating upgrades versus downgrades, with an aggregate ratio higher than 1.0. Finally, economic growth below trend heralds the arrival of late cycle conditions. At the same time, monetary policy rates are typically close to, or at, the highest level in the cycle, and credit ratios begin to deteriorate as organic growth opportunities are scarcer and leverage ticks up. As a result, risky assets tend to look expensive during late cycle conditions, with valuations appearing stretched.
In late 2021, the global economy was moving towards mid cycle. Growth projections for 2022 were significantly above average and central banks in developed markets were just starting to warm up market participants to the upcoming tightening process. Then in Q1 2022, inflation stickiness caused central banks to severely adjust their interest rate projections. Along with the Russian invasion of Ukraine, the changing central bank policy outlook precipitated significant turmoil, given a tightening of financial conditions and downward revisions to growth expectations. Consequently, press speculation has quickly evolved to consider whether the economy has moved to late cycle and is about to face an imminent recession.
Although recession probabilities have increased, the current situation is not consistent with what we typically experience during late cycle. Growth projections for the world as a whole, after the aforementioned adjustments, are consistent with long term averages. In particular, private consumption remains robust, as evidenced by yesterday's U.S. GDP prints that showed consumption accelerated during Q1 to a 3.1% annualised year-on-year rate. Yesterday's release places consumption above the average of the last 30 years (we commented on the strength of consumers' balance sheet here, Just How Healthy is the Consumer ). In addition, central banks have just begun their monetary policy tightening journey, which will, of course, be much speedier than previous periods of tightening.
Meanwhile, the credit quality of corporates worldwide is far from deteriorating. Looking at Moody's data for Q2, we have 1.53 upgrades for every downgrade in European high yield so far, while the number is 2.33 in investment grade. In the U.S., the analogous figures for high yield and investment grade are 1.14 and 5.50, respectively. The last time we experienced late cycle conditions was in 2019. Back then, high yield markets underwent roughly 0.5 upgrades for every downgrade. An economy with growth at long term averages, central banks just beginning to tighten monetary policy and increasing credit quality is not one that has entered late cycle.
Lastly, we have to discuss valuations. In 2019 spreads were tight by historical standards. This is key to late cycle positioning. A significant reason for considering switching out of credit into rates during the later stages of a credit cycle is that spreads are not attractive enough to compensate for credit risk. At the moment, spread levels incorporate quite a steep slowdown in our view. Furthermore, this spread widening has come when companies are actually improving their credit quality, and consumers remain well positioned; neither are indicators consistent with the classic late cycle environment. Amongst other things, this is why default projections remain very low even after growth forecasts have suffered. Even though spreads can go wider, it is worth keeping in mind that high yield spreads at circa 500bp do price in a reasonable increase in defaults already. Valuations of risk off assets have also corrected significantly. As we have mentioned in the past, with 10-year U.S. Treasuries yielding around 3%, we are much closer to where we think terminal rates will reach in this cycle. Therefore, we believe a decent entry point to extend duration and bring much-needed stability to portfolios has arrived.
In conclusion, we do not think the present conditions are compatible with definitions of a late cycle environment. The cocktail of bad news that hit the global economy in 2022 luckily came when we were approaching mid cycle from a position of strength. Consequently, we believe that the economy will arrive at a late cycle sooner than we previously expected, but we are not there now. The distinction is important as the alternative cost of positioning too early for late cycle dynamics when, for example, U.S. high yield and Coco bonds yield close to 8% and 7%, respectively, in a context of low default rates is high.