Market cycles: a slightly different flavour

One of the most dangerous phrases in the investment world is, ‘This time it’s different’. It usually gets wheeled out near the end of a bull market to explain why prices will rise forever due to a new era of permanent prosperity; or near the end of a bear market to explain why prices will fall forever due to fundamentally negative forces. And usually when it is pronounced en masse it marks the turn in the cycle, and those who uttered it soon look foolish.

So the phrase needs to be used with caution. Although the fundamental drivers of the economic and investment cycle (such as human psychology, the tendency for economic growth and asset prices to revert to a long run mean and the countervailing force of economic policy) remain alive and well, it should be recognised that there are subtle differences in each cycle. And these differences are significant enough to be relevant to investors.

And there are certainly differences in the current economic and investment cycle that investors need to be aware of. This was already apparent throughout the downturn phase, which featured a financial catastrophe the likes of which had not been seen before in the post-war period. The financial crisis, the earlier monetary tightening and a normal inventory downturn all combined to result in the first slump in global gross domestic product in the post-war period.

Typical cyclical recoveries have seen the US lead the way out and drag up the rest of the world. This time around, it looks a little different.

Uninspiring conditions in developed countries

While the financial constraints in the US don’t appear to be stopping a recovery, they will likely constrain it. As a result of difficulties in the US banking system, credit creation is likely to be seriously impaired for some time — and US households are likely to be far more focused on reducing their debt levels following the slump in the value of their assets.

Despite the potential for a solid initial bounce, the outcome is likely to be relatively constrained economic growth in the US for the next few years. This is likely to be reinforced as US economic policy moves towards a greater focus on regulation, which will increase the cost of doing business in America.

At the same time, structural problems and poor demographics suggest that it is hard to see either Japan or Europe filling the void left by the US. And most advanced countries will need to deal with very high public debt to GDP ratios, which will provide another constraint to growth. So the overall picture for mainstream developed countries points to relatively sub-par and unexciting growth over the next five or so years.

Given substantial amounts of excess capacity in the advanced world, combined with subdued credit growth, it’s hard to see inflation being a problem. Sub-par growth and low inflation means that monetary policy in developed countries is likely to remain pretty easy.

… but inspiring conditions in the emerging world

Against this though, the outlook for the emerging world is much brighter. These countries are not lumbered with the same debt problems as many advanced countries, they tend to have far more favourable demographics, and they have plenty of scope to boost their own consumption to make up for weaker growth.

Reflecting this, it is the emerging world leading the way out of the global recession, with growth in many Asian countries rebounding earlier and much faster than has been the case in the developed world — highlighted by China’s annualised growth rebound of 17 per cent in the June quarter and 10 per cent in the September quarter.

But not only is the emerging world leading the recovery, this is the first global economic recovery to occur with the emerging world actually being a bigger proportion of the global economy than the developed world. In fact, consumer spending in the emerging world is now equal to that in the US.

This all hangs on the hope that the global economy can rely less on the US consumer.

So while there is nothing new in a cyclical economic upswing, the big difference this time around will be the much greater role played by emerging countries.

What does it all mean for investors?

The greater importance of the emerging world, combined with the constrained, more fragile outlook in the US and other developed countries, has a number of implications for investors.

First, investors need to move away from the concept of traditional international equity funds and allocate a lot more to strongly growing emerging countries. Traditional international equity funds are benchmarked against indices that have an 80 or 90 per cent exposure to slow growth advanced countries, and are lagging way behind the reality that the emerging world is now playing a much bigger role in the global economy. And this role is set to get even bigger.

Second, growth in the emerging world is commodity intensive. It now consumes more oil than developed countries, which suggests an allocation to commodities should also be considered.

Third, Australia’s strong exposure to high-growth Asia countries and commodities combined with its rapid population growth provides a positive backdrop for the local share market, and suggests that investors should maintain a bias towards Australian shares.

Fourthly, strong commodity prices are likely to be favourable for commodity currencies — such as the Australian dollar — versus currencies such as the US dollar, euro and yen. This points to a need to be aware of unhedged exposures to traditional offshore investment markets.

Fifthly, the greater fragility of US consumers, the risks associated with rising public debt levels and the inherent volatility of emerging markets means that the global economic and investment cycle could become more volatile.

Finally, it’s worth observing that bubbles are part and parcel of investment markets and they often form from the ashes of the previous bust. It’s hard to see another bubble forming anytime soon in the US; after all, they have had the last two (that is, the tech and housing bubbles). But as long as the combination of easy money conditions globally, the positive fundamentals in the emerging world and the transition to a more China-centric world inspires the imagination of investors, there is a good chance that the next bubble will be in emerging markets and related trades (such as commodities). That said, bubbles take four or five years to form, and it is still very early days yet.

Different enough to matter

So while there is always a cycle and there will always be bubbles, they are always a bit different. This time around the rise in the relative fortunes of emerging countries versus developed countries is different enough to have significant implications for investors.

Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.