In mid-cycle is where winners and losers tend to diverge – aka alpha over beta.
The U.S. economy is moving rapidly past the early phase of the expansion, and is now in mid-cycle.
The recovery so far has been swift, thanks to timely and aggressive monetary and fiscal policy stimulus.
As a result, the associated price action has also generated spectacular returns – the S&P rose by 14% in 2020, and a further 18% so far this year.
But the easiest gains of this recovery are mostly already made.
Indeed, some of the indicators we watch, such as household consumption, residential housing market investment, and companies’ earnings revisions have likely reached their cyclical highs.
Will mid-cycle pass just as quickly?
We think we still have a lot of economic expansion ahead of us.
The labour market is still roughly 10 million jobs short of its pre-pandemic level, and it will likely take more time and more retraining to get the last 10 million workers re-employed.
Unlike the last cycle, the Fed is committed to a full recovery this time.
A big difference this time is that, while normally mid-cycle means Fed will be raising rates, this time around we think they are years away, with liftoff not expected until the second half of 2023.
We also expect to see some productivity improvement appear post-pandemic, and as a result, although margins may have peaked they can likely remain elevated for longer this time.
What are the key investment implications? There are five points to remember:
First, in mid-cycle, economic activity data tends to matter less, and the market tends to become less correlated with macro data.
Second, equity market returns typically revert towards trend in mid-cycle. So manage your total return expectations to be trend-like.
Third, while early cycle favors cyclical sectors, mid-cycle tends to favor quality businesses with structural growth, over cyclicals. Technology remains a recommended sector, and we also recently upgraded healthcare stocks.
Fourth, cross asset correlation tends to fall, and dispersion between sectors and stocks increases.
Mid-cycle is typically when secular winners emerge.
So we need to think about alpha over beta and active management.
Lastly, core fixed income becomes a viable solution again, at least from a cyclical perspective.
Although with rates structurally lower for longer, core fixed income may still be unsuitable for many clients, in which case it is still important to consider using alternative assets to boost return.
To summarise, expansions don’t die of old age.
Despite being past the peak we still think the U.S. economy can see more quarters of expansion ahead.
But the overall market will likely see less upside than in the early cycle, and from here it is more important to manage risks and pick the right winners with good fundamentals and secular growth potentials. The U.S. economy is moving rapidly past the early phase of the expansion, and is now in mid-cycle.
The recovery so far has been swift, thanks to timely and aggressive monetary and fiscal policy stimulus.
As a result, the associated price action has also generated spectacular returns – the S&P rose by 14% in 2020, and a further 18% so far this year.
But the easiest gains of this recovery are mostly already made.
Indeed, some of the indicators we watch, such as household consumption, residential housing market investment, and companies’ earnings revisions have likely reached their cyclical highs.
Will mid-cycle pass just as quickly?
We think we still have a lot of economic expansion ahead of us.
The labour market is still roughly 10 million jobs short of its pre-pandemic level, and it will likely take more time and more retraining to get the last 10 million workers re-employed.
Unlike the last cycle, the Fed is committed to a full recovery this time.
A big difference this time is that, while normally mid-cycle means Fed will be raising rates, this time around we think they are years away, with liftoff not expected until the second half of 2023.
We also expect to see some productivity improvement appear post-pandemic, and as a result, although margins may have peaked they can likely remain elevated for longer this time.
What are the key investment implications? There are five points to remember:
First, in mid-cycle, economic activity data tends to matter less, and the market tends to become less correlated with macro data.
Second, equity market returns typically revert towards trend in mid-cycle. So manage your total return expectations to be trend-like.
Third, while early cycle favors cyclical sectors, mid-cycle tends to favor quality businesses with structural growth, over cyclicals. Technology remains a recommended sector, and we also recently upgraded healthcare stocks.
Fourth, cross asset correlation tends to fall, and dispersion between sectors and stocks increases.
Mid-cycle is typically when secular winners emerge.
So we need to think about alpha over beta and active management.
Lastly, core fixed income becomes a viable solution again, at least from a cyclical perspective.
Although with rates structurally lower for longer, core fixed income may still be unsuitable for many clients, in which case it is still important to consider using alternative assets to boost return.
To summarise, expansions don’t die of old age.
Despite being past the peak we still think the U.S. economy can see more quarters of expansion ahead.
But the overall market will likely see less upside than in the early cycle, and from here it is more important to manage risks and pick the right winners with good fundamentals and secular growth potentials.
The recovery so far has been swift, thanks to timely and aggressive monetary and fiscal policy stimulus.
As a result, the associated price action has also generated spectacular returns – the S&P rose by 14% in 2020, and a further 18% so far this year.
But the easiest gains of this recovery are mostly already made.
Indeed, some of the indicators we watch, such as household consumption, residential housing market investment, and companies’ earnings revisions have likely reached their cyclical highs.
Will mid-cycle pass just as quickly?
We think we still have a lot of economic expansion ahead of us.
The labour market is still roughly 10 million jobs short of its pre-pandemic level, and it will likely take more time and more retraining to get the last 10 million workers re-employed.
Unlike the last cycle, the Fed is committed to a full recovery this time.
A big difference this time is that, while normally mid-cycle means Fed will be raising rates, this time around we think they are years away, with liftoff not expected until the second half of 2023.
We also expect to see some productivity improvement appear post-pandemic, and as a result, although margins may have peaked they can likely remain elevated for longer this time.
What are the key investment implications? There are five points to remember:
First, in mid-cycle, economic activity data tends to matter less, and the market tends to become less correlated with macro data.
Second, equity market returns typically revert towards trend in mid-cycle. So manage your total return expectations to be trend-like.
Third, while early cycle favors cyclical sectors, mid-cycle tends to favor quality businesses with structural growth, over cyclicals. Technology remains a recommended sector, and we also recently upgraded healthcare stocks.
Fourth, cross asset correlation tends to fall, and dispersion between sectors and stocks increases.
Mid-cycle is typically when secular winners emerge.
So we need to think about alpha over beta and active management.
Lastly, core fixed income becomes a viable solution again, at least from a cyclical perspective.
Although with rates structurally lower for longer, core fixed income may still be unsuitable for many clients, in which case it is still important to consider using alternative assets to boost return.
To summarise, expansions don’t die of old age.
Despite being past the peak we still think the U.S. economy can see more quarters of expansion ahead.
But the overall market will likely see less upside than in the early cycle, and from here it is more important to manage risks and pick the right winners with good fundamentals and secular growth potentials. The U.S. economy is moving rapidly past the early phase of the expansion, and is now in mid-cycle.
The recovery so far has been swift, thanks to timely and aggressive monetary and fiscal policy stimulus.
As a result, the associated price action has also generated spectacular returns – the S&P rose by 14% in 2020, and a further 18% so far this year.
But the easiest gains of this recovery are mostly already made.
Indeed, some of the indicators we watch, such as household consumption, residential housing market investment, and companies’ earnings revisions have likely reached their cyclical highs.
Will mid-cycle pass just as quickly?
We think we still have a lot of economic expansion ahead of us.
The labour market is still roughly 10 million jobs short of its pre-pandemic level, and it will likely take more time and more retraining to get the last 10 million workers re-employed.
Unlike the last cycle, the Fed is committed to a full recovery this time.
A big difference this time is that, while normally mid-cycle means Fed will be raising rates, this time around we think they are years away, with liftoff not expected until the second half of 2023.
We also expect to see some productivity improvement appear post-pandemic, and as a result, although margins may have peaked they can likely remain elevated for longer this time.
What are the key investment implications? There are five points to remember:
First, in mid-cycle, economic activity data tends to matter less, and the market tends to become less correlated with macro data.
Second, equity market returns typically revert towards trend in mid-cycle. So manage your total return expectations to be trend-like.
Third, while early cycle favors cyclical sectors, mid-cycle tends to favor quality businesses with structural growth, over cyclicals. Technology remains a recommended sector, and we also recently upgraded healthcare stocks.
Fourth, cross asset correlation tends to fall, and dispersion between sectors and stocks increases.
Mid-cycle is typically when secular winners emerge.
So we need to think about alpha over beta and active management.
Lastly, core fixed income becomes a viable solution again, at least from a cyclical perspective.
Although with rates structurally lower for longer, core fixed income may still be unsuitable for many clients, in which case it is still important to consider using alternative assets to boost return.
To summarise, expansions don’t die of old age.
Despite being past the peak we still think the U.S. economy can see more quarters of expansion ahead.
But the overall market will likely see less upside than in the early cycle, and from here it is more important to manage risks and pick the right winners with good fundamentals and secular growth potentials.
The U.S. economy is entering mid-cycle. The fact that the early cycle in the U.S. was quick does not mean the mid-cycle will be similarly fast. The progression of the business cycle is driven by labor market slack and/or the size of “imbalances” (think asset bubbles, overinvestment, or excessive debt accumulation). As a cycle progresses slack tends to diminish and imbalances grow, prompting the Fed to tighten policy in an effort to cool inflation or right size excesses. History tells us this is no easy task and that soft landings are hard to come by. In this note, we walk through where we are in the cycle, define why mid-cycle need not be as rapid as the early cycle, and crack open a playbook for investors.
To be clear, it’s not lost on us that the U.S. business cycle isn’t everything. After all, in the middle of the last U.S. cycle, economies outside of the U.S. went into deep recessions, which had material impacts on markets (e.g., commodities). In addition, we still believe that in H2 2021 we will see a bit more tactical early cycle price action, and importantly, more treasury curve steepening on the back of Catalysts like the infrastructure bill making its way through Congress (currently awaiting vote in the House), virus cases peaking, and the Fed further reinforcing its more dovish framework. But the purpose of this piece is to step back and define the roadmap for the next couple of years, which will likely look a lot more mid-cycle than early cycle, in our view.
Economists use a range of business cycle indicators to help measure slack and excesses in the economy. However, it is very rare for all indicators to tell you the same signal, thus here we use an index reflecting the relative value of these indicators1 (by comparing them to their own history), to more objectively define where we are in the cycle. The level of the index generally rises throughout the course of the business cycle, with recessions (gray bars) following the highest levels. After economic downturns, it resets back to low levels, indicating renewed slack in the economy after which the post-recession recovery ensues. Following the COVID shock, the index did not reset lower to nearly the extent it did post-GFC and has recovered to mid-cycle quickly (roughly five years faster than post-GFC); another reason not to compare the COVID recession to the GFC.
There are three reasons why the mid-cycle need not be as rapid as the early cycle:
1) There is still a substantial amount of slack in the U.S. economy. Although in aggregate our business cycle indicators flash mid-cycle, there is still slack in the labor market. Total employment is running ~10M jobs below its pre-COVID trend2. While we are optimistic on the labor market recovery and look for the unemployment rate to fall towards 4.7% by the end of the year, gains thereafter will likely be slower. Roughly 65% of those unemployed now consider themselves permanently unemployed, similar to the pre-COVID average, which suggests that getting back to work may be prolonged with re-training likely required for a sizable portion of the labor force.
2) The Fed’s new “FAIT” framework should extend the mid-cycle phase. The Fed’s Flexible Average Inflation Targeting framework, “FAIT”, aims to average 2% inflation over a business cycle – a task they failed to accomplish last cycle. The framework suggests inflation should overshoot 2% in the early stages to compensate for when inflation declines in a recession, but in practice they will likely wait longer than they have historically to start tightening policy, in order to facilitate the overshoot. Typically, the Fed hikes rates mid-cycle and in the last two business cycles the Fed commenced liftoff when our indicator was at a similar level as it is today. While we are entering mid-cycle, the Fed is likely years away from raising interest rates, delaying the typical monetary policy-induced softening in activity. We expect Fed liftoff in the second half of 2023.
3) We expect potential GDP to rise post-COVID (to 2.25% versus 1.8% post-GFC), predicated on a pickup in productivity. All else being equal, rising productivity should offset inflationary pressures. A classic example: if a company is able to automate a task historically performed manually, that increase in productivity likely reduces the company’s need for labor. Without having to pay for labor the company is able to sell its product at a lower price. Below we show GDP-based corporate profit margins over the course of an average business cycle compared to unit labor costs (i.e., wages adjusted for productivity). While all cycles are not the same, margins tend to peak in mid-cycle as unit labor costs begin to rise (driven by a tightening labor market). Last cycle, S&P 500 margins peaked in 2018. However, on the back of higher productivity it’s possible that margins this cycle can expand a bit further or remain elevated for longer (even in the face of a tightening labor market).
As the U.S. economy transitions into this new phase in the cycle, we attempt to crack open a “Mid-Cycle Playbook” for investors. Here we lay out some key pillars of strategic multi-asset investing:
1) Getting the macro right is always important, but it’s less important mid-cycle. All we have done is talk macro for the past year and a half, as we should in early-cycle when broad economic trends are so important for risk assets. As the economy transitions to mid-cycle, investing becomes less about each twist and turn in economic data. Why? The economy has firmly recovered from the downturn, slack is elevated, and excesses are limited, suggesting the probability of the next downturn is relatively low. The market becomes less correlated to the macro data.
2) Manage your total return expectations to trend-like; nonetheless volatility-adjusted dollars favor stocks over bonds. Equity market returns typically revert towards trend in mid-cycle. After a huge run over the last 12 months (S&P 500 up 35%!) that’s a sizeable reversion to the mean. Historically, this is where US exceptionalism really shows itself and that divergence has been especially pronounced since the turn of the century as secular winners have been largely US-based. On a volatility adjusted basis (i.e., Sharpe ratio), the S&P 500 has looked more attractive in mid-cycle relative to early cycle. However, this has not been the case for USD-based investors looking outside of the US. The case for international equities, notably emerging markets, becomes more challenging in mid-cycle as diverging monetary policies become the key theme for FX markets. The US Dollar, after being an early-cycle laggard, tends to see strength during the mid-cycle phase.
3) Adjust your equity factors – growth over cyclicals. Early-cycle favors consumer-led, highly volatile cyclical companies that benefit from low interest rates - think housing, transports, autos, materials, and semis. C-suite executives generally question if the recovery is sustainable and keep both inventories and costs as low as possible, leading to high (yet fleeting) pricing and margins. The Q1 2021 experience saw massive earnings surprises for cyclicals and financials, while growth and non-cyclical earnings surprises lagged – consistent with this narrative.
As we move to mid-cycle, reversion to trend-like fundamentals commences (consistent with point #2 above): 1) earnings growth overall normalizes – this cycle we look for earnings growth to moderate from 39% in 2021 to 10% in 2022. Furthermore, we expect earnings growth deceleration to be particularly acute in cyclicals relative to growth (tech and other non-cyclicals); and 2) as corporate confidence grows, spending on both labor and CAPEX should increase towards trend. The unusually low level of capex spending over the last decade, in conjunction with rising spending intentions and a focus on renewable energy, sets the stage for industrial and material companies this cycle.
In mid-cycle, the market historically rewards quality businesses with structural growth, over cyclicals; technology is a recommended sector of ours, and we’ve recently upgraded Healthcare stocks. Regarding the upgrade of healthcare stocks, recall the sector has managed to grow earnings during each of the last 25 years, yet has underperformed the market by 20% since 2019 due to its lack of cyclicality.
4) Winners tend to emerge mid-cycle – get the themes right. Early-cycle, cross asset correlations tend to be high and total returns strong – picking the right sectors is less important than simply getting risk exposure – aka beta over alpha. In mid-cycle, the narrative flips as correlations between sectors declines and dispersion between sectors and stocks increases – this is where secular winners tend to emerge – aka alpha over beta. This same chart shows that active management is more important as we progress through the business cycle. In the search for the secular favorites today, we are focusing on tech, ESG, and crypto/blockchain.
5) Core fixed income is a viable solution again. In the early cycle phase, when searching for yield we have largely shunned core fixed income in favor of extended credit, structured notes, and illiquid alternatives. As rates rise towards our 2.1% 10-year Treasury outlook (mid-year 2022), that’s a level where core fixed income will be a more viable solution for yield-seeking investors and a place where we should be neutralizing our short base.
Post-COVID many of us have been relying on structured notes as a source of income – structured notes are of course riskier than core fixed income, but a completely logical adjustment. In a recession and in the early-cycle phase, investors are well compensated for selling a 20% out of the money put on the SPX (the VIX tends to be higher in this phase, which is the main driver of structured note returns) compared to core fixed income (rates are low early-cycle as the Fed tries to stimulate the economy). However, as we progress through the mid-cycle the compensation wedge between selling puts and core fixed income should narrow as volatility normalizes and the Fed removes accommodation – so be ready to rotate back to core fixed income. This is not to say we won’t rely on structured notes in mid-cycle, but we will most likely focus on individual names rather than index level notes (“alpha” over “beta”).
Footnotes:
1Business cycle indicator inputs: Business cycle indicator inputs include output gap, capex as % of potential GDP, residential investment as % of potential GDP, core cyclical PCE inflation, unit labor cost growth (8-quarter average), consumer interest payment growth, unemployment rate, consumer confidence, and 2yr10yr U.S. treasury yield spread.
2 Labor market data: U.S. Bureau of Labor Statistics as of July 31. 2021.
The Standard and Poor’s 500 Index is a capitalization-weighted index of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of available market capitalization.
The Chicago Board Options Exchange's CBOE Volatility Index (VIX) is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days.
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