This strange economic cycle is finally starting to look familiar

There is little disagreement among investors and economists that the last few years have been highly unusual in many respects. An inflationary shock in developed markets, one of the fastest rate hiking cycles on record, the worst year in decades for government bonds (2022), and mild recessions with no movement in unemployment are just a few of the dynamics that have strayed from recent norms.

In this context, it is no surprise that there has been wide disagreement as to where risk assets such as corporate bonds and equities should be trading. It has been difficult to identify whether the global economy was early-, mid-, or late-cycle, and therefore just as difficult to gauge if valuations were a fair reflection of the macro picture.

Time is a great healer, though. As we move into the second half of 2024, the macro picture and its relation to spreads is starting to better resemble past episodes.

We would characterise a late-cycle environment as one where growth is below its potential rate but not negative, central banks are in easing rather than tightening mode as inflation is not the biggest concern, and credit spreads are relatively tight compared to history. Looking at growth, projections for Europe and the UK for 2024 are for a mild acceleration from close to zero last year. Nevertheless, the consensus (via Bloomberg) is for real growth in both to hit 0.7% for the year, which is below trend. For 2025 the expectation is another marginal increase in both as well. In the US, the consensus (again via Bloomberg) projects a growth deceleration in 2024 to 2.3% and a further drop to 1.8% in 2025. We would say these levels are consistent with the US economy dipping mildly below potential next year. Interestingly, but perhaps not surprisingly, Europe’s 2024 growth projections have been revised higher from low levels while the US projections have been revised marginally lower from high levels in recent months. Growth forecasts are of course influenced by trajectory – when growth is accelerating, projections tend to be revised higher and vice versa.

Inflation in developed markets is expected to continue moving towards target. There is still considerable uncertainty as to when exactly the destination will be reached, but there are now fewer questions as to whether it will be reached. Regarding monetary policy, in emerging markets central banks have already started easing for the most part, while in developed markets (excluding Japan) the process is in motion with the Federal Reserve expected to follow the Swiss and Eurozone central banks in cutting later this year.

Taking growth, inflation, and central bank forecasts together, we would say that the current situation resembles a more typical late-cycle environment. Uncertainty has not gone away, but for market participants the picture looks a little more familiar than previously.

What could this potentially mean for positioning?

If we are indeed navigating a late-cycle environment, we would expect spreads to be tighter than historical averages. This is a fair description of the vast majority of credit markets today. In fixed income, in late cycle it is generally prudent to have a portfolio that has a higher average rating and a shorter credit spread duration than the norm or the benchmark. Comparing the current cycle with the post-2008 one, we think there is an even stronger rationale to maintain higher credit quality as the additional yield for going lower in ratings is not very large as a percentage of the overall yield. In the previous cycle, due to base rates being so low, investors could sometimes double their yield by going down a notch or two in rating, especially in the euro markets. This is not the case at the moment. This is also reflected in the lack of sponsorship that more problematic, lower rated credits have compared to last cycle.

For government bonds, one would typically favour a larger exposure and longer duration in late cycle. The caveat this time around is that the curve is already inverted, particularly at the short end. In other words, a certain number of rate cuts are already priced in. Therefore, while exposure to rates should perhaps still be higher than the norm, we do acknowledge that valuations in government bonds mean we are unlikely to see a large rally here unless risks of a recession increase materially.

Last but not least, it is important to mention that late-cycle conditions can last for long periods of time. Spreads have spent a much larger portion of history trading below their long-term average than they have above or at the average. In our view, this is not the point in the cycle to be taking undue risks, but it is also not opportune to be completely out of the market waiting for the absolute perfect timing to enter aggressively, as it might be a very long wait indeed.

A balanced portfolio with both rates and higher-than-average quality credit, with sufficient levels of liquidity to enact change quickly, seems to us the best way of taking advantage of the attractive yields on offer at this juncture, given a late-cycle backdrop that is looking increasingly typical.