Knowing the Past to Understand the Present and Plan for the Future

Economy and Markets

ECONOMIC CYCLES (adapted from www.investorpolitico.com published on 8 August 2013)

The theory of the economic cycles is about “where we are now”. Understanding in what part of the cycle we are, is essential in order to position the investments for the long period and not be caught up in short term views.

  • The economy is driven by 4 major cycles which, due to the technology and worldwide integration are constantly becoming shorter.
    The market cycle is usually shorter than the economic cycle as the markets are always forecasting at least 6/9 months ahead.

1. Ultra Long Cycle 70-100 years driven by technological advancement.

  • This cycle (in civilian use) has started around 1955 and probably has an end towards 2015/20.

  • In 1955 the jump in technology from the Second War World became available for civilian use and it was the primary cause, together with the reconstruction, of the 1960s boom due to the jump in productivity and efficiency.

  • Even if it hard to forecast such a technological jump, we are a bit overdue on a time basis. Our main thesis we are at the start of the new technological jump. The main factors that currently drive this leap forward are cloud technology, cashless transactions, electric cars mobility and the very start of robotics, autonomous driving cars, quantum computing and genetics.

  • The effect will be start be felt probably from 2015/18 in the markets.

2. Long Cycle 20 years driven by political/resources events

 

  • The last 2 Long cycle start to be interesting

  • The last Long Cycle has been 1989 -2008

  • In 1989 the USSR collapsed and a few years after China opened up to the West

  • These two unrelated events completely changed the investment scenario, due to a few factors.

  • New and growing demand for product from the new client base

  • Cheap workforce due to the young masses entering the market

  • Availability of cheap credit

  • Availability of cheap resources

  • Non involvement of politics in the market

  • These factors contributed to easy 5 years economic cycle positive for shares and capital markets.

Statistical Market Outcome: relative long rallies and shallow corrections. Short and small wars. Constant but not overwhelming jump in technology. Cheap credit would cause occasional bubbles (Australia 1992 Real Estate, US Tech Bubble 2001). Alternative strategies are relatively inefficient. Strategic asset allocation 70% equity and 30% bond works perfectly in this scenario.

In 2008 the cycle came to an abrupt end as the binge cheap credit bubble exploded. In essence the cheap credit had a contraction effect in the bank profit margin. In order to maintain the level of profit requested by the shareholders the banks created ever more sophisticated products that ultimately imploded. Australia real economy was mostly spared due to the oligopolistic nature of the Australian banks – which are relying on good old fashioned retail loan for profit – and the massive credit expansion in China.

 

 

The New Cycle (2008 – 2025) has a few special characteristics

  • Scarcity of resources

  • Ageing of population – rising costs

  • More expensive workforce and rise of robotics (as it is happening in Japan)

  • Unavailability of cheap credit (interest rates are low, but banks are more strict in lending requirement, Government will impose stricter capital rules to prevent 2008 style events, but effective creating a fiscal tightening scenario)

  • Involvement of Politics in the market (direct intervention of Federal Reserve, Currency and market manipulation) tantamount of economic warfare

  • Statistical Market Outcome:This environment will lead to short rallies and rapid corrections. The usual safe havens (such as Bonds, gold) will work, but only for finite periods on a rotation basis. The only asset which maintains uncorrelated properties are currencies.

  • Alternative strategies are essential in this period, but specially what I define an “adaptive asset allocation” which is a mix of tactical and strategic asset allocation constantly adapting to new scenarios and a core of positions in companies  like Google which have pricing power.

  • In this period, as State Entity competies for resources, major conflicts can easily breakout and so also technological breakthroughs. There is the rise of the Mega Corporation as supranational influence power (brilliantly explored by the Sci Fi writer P. Dick in what then became the movie “Blade Runner”)

Short Cycle 5 years – driven by political adjustments

  • The last short cycle started in 2009 (so economic cycle ends in 2014, but market cycle finish in 2013!)

  • This cycle is a transition cycle to a new world so determined by shock waves rallies and crashes until the world adapts to the new order.

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  • Statistical Market Outcome:This cycle will finish 2013 (this blog has been written the 8 August 2013), spurring a major rally. Start date to be determined. Maybe August – October 2013. Unluckily, statistically, this kind of rally ends with a serious war (Vietnam, Israel wars in the 1970s) (Update 2015: the Middle East is specially problematic as, overtly or covertly, all major powers are participating, including China as a weapon supplier for Iran and Syrian Government)

Ultra Short Cycle 1 year – driven by company re stocking pattern and political shocks

  • This is usually driven by the restocking habits of the companies (last year was a restocking year and profit driven by cost cutting – not increased sales) and policy outcomes. In this case, in general, company targets are harder to be achieved – but the market at this moment is fully supported by political intervention.

  • Political shocks are ever present in the short term. Currently the media outlets are showing an increased level of control (also in our Western democratic countries) to assuage political and economic strategies of our governing bodies.

 

Where are we now?

The years between 2010 and 2025 will be classified as a transition period between 2 Ultra long 70 years’ technological periods

They mainly be characterised by 2 events

  • Politically, the USA from the only Superpower will become a First Amongst Equals as it will have to contend at least with China and Russia. The US and USD will be not anymore all-dominant. A shift in USD as only reserve currency has such a destabilising effect that would require an entire book to be analysed properly.

  • Technologically, cloud computing, robotics, electrical or hybrid autonomous car will become more and more available and they change the way we live and do business.

As new sectors rise and old sector disappear, benchmark following strategies will lag as benchmark gets updated after the fact strategy (Dow Jones 30: each average component (company) has changed 52 times since its start on 26 May 1896!).

2009 to 2015, “Shadow Bull Market’.

I call this period as Shadow Bull Market because, notwithstanding the various crises, it has been driven by two simple mega trends:

  • Quantitative Easing. In simple words the share market goes up when there are more buyers than sellers. With the US Federal Reserve and all the main reserve banks of the world (People Bank of China, European Central Bank, Bank of England, Bank of Japan)  printing ever more money there were always more money. Hence the bull run, notwithstanding the backdrop of bad economic data and real crisis (but somewhat manageable)

  • Return to the Mean. The markets have always a latent tendency to return to the mean as this is the main strategy adopted by institutions (the retail investor strategy is typically a momentum strategy (following the masses). For example the Australian market mean is ASX200: 5,500 and that where the market was heading.

In this period a benchmark following strategy would have achieved the same returns of a real return strategy, if you had the nerve of ignoring the noise.

 

The future

The situation is much more complex, some of the issues are

  • Quantitative Easing:  essentially the various Central Banks managed to escape the Global Financial Crisis printing an enormous quantity of money via debt. This strategy created markets distortions (especially felt at large cap index level such as the Dow Jones 30 and ASX 50 and the Government Bond market) and also pose the questions of how the Central Banks will be able to unwind the positions as it has never been attempted before.

  • The US Federal Reserve and soon after the Bank of England will start increase interest rates, while other Central Banks (European Central Bank, People Bank of China, Bank of Japan) are still continuing in quantitative easing). So we do not have any more a strategic alignment between world banks authorities. The last time it happened (1937/38) the Central Banks acted too fast and plunged the markets in a secondary recession that hastened the outbreak of the Second World War.

  • These crises are not anymore financial per se, but human (Middle East, European mass immigration, old age). They simmer for long, but they are not easy to control or manipulate in the long term.

  • The market has returned to the top, so the return to the mean (correct  valuation of the market strategy), on average does not work anymore

  • Currency wars create definite winners and definite losers

  • The rise of Exchange Traded Funds and algorithmic trading allow large trade to happen almost instantaneously, also in market with typical low level of volumes creating potential market shocks.

  • Deflation issues, similar to the Japanese lost decades (the Nikkei 225 is currently hovering 20,000 while the top in the early 1990s was over 40,000), are simmering everywhere as low oil price and the Chinese slowdown are “deflation exporters”.

  • Proxy conflict between US, China, Turkey, Saudi Arabia, Iran and Russia will be ever more evident, increasing the potential real confrontation even as consequence of errors.

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  • Technological advancements are starting to have real impact in large established industries like the car industry.