The following is taken from the latest Quarterly Insights commentary from Glenmede.
"History doesn't repeat itself, but it does rhyme" – Mark Twain
The cycle is repeating, or at least rhyming
The global financial markets and economy have been unable to return to steady growth following the financial crisis that began in 2008. This has not been without occasional bouts of optimism, where momentum builds as market participants embrace a growing expectation of reaching a critical escape velocity. However, these sentimental boosts have been fleeting. While each round has been distinct, it is worthwhile to note that the cycles are eerily similar.
Cycling quickly to a growth scare
The current cycle is proceeding at an unusually brisk pace. Despite January's rally, the leading economic indicators we monitor showed signs of moderating growth in April, and have since re-entered the growth-scare phase. If the cycle repeats its pattern of the past two years, this will continue until market participants over-extrapolate the trend, again stirring fears of an impending recession. Yet historically, in instances when declining economic cycles have incited recessionary fears, the cycles were further apart with lengthy periods of growth in between. An annual cycle is unusual indeed and one that needs further examination.
Excess debt and an inconsistent cyclical policy response
Not only are the speed and magnitude of the present cycle unusual, but today's overall economic environment is quite different from historical norms. We believe global excess debt and insufficient policy response are to blame. Deleveraging, the reduction of balance sheet debt, is quite obviously a drag on economic activity. Growth becomes muted as previous borrowers repay debts and lenders absorb losses from negligent debtors. But there is more to it. While borrowing is a natural process, deleveraging runs counter to the typical impulses of consumers, governments and most market participants. Debt reduction can cause the economy to halt or even decline if done too rapidly. If pursued gradually, this otherwise 'unnatural' process can become palatable. Monetary policy, by stimulating inflationary pressures, can provide an offset to the deflationary pressures caused by deleveraging. However, when inflationary fears become layered with unrealistic expectations of policymakers, the reality that deleveraging will take time and effort proves a hard pill for voters and policymakers to swallow.
The next stage: Policy response
With economic momentum weakening and the latest growth scare unfolding, policy response is the next stage. Once economic concerns reach a high enough decibel level, central bankers will likely again stimulate the economy. Although investors will initially doubt the central banks' ability to engineer an economic resurgence, a monetary policy response should stabilize the economy and buy more time for legislators.
Beautiful deleveraging: Practice (repetition) makes perfect...eventually
Some practitioners have penned the term "beautiful deleveraging" to explain the ideal balance between monetary policy (stimulus) and fiscal policy (deleveraging). We believe this ideal state is nearly impossible to reach for a multi-participant global financial system. Yet we believe a version, albeit less stable, may occur if central banks continue to respond quickly enough each time to prevent a complete unwinding of the financial system. While no measure alone, monetary or fiscal, has been sufficient to end the rolling debt crisis, the cumulative effect of the cycles and repetitive policy responses should lead to resolution.
Investment strategy: Underweight risk assets, maintain focus on the middle
In the meantime, we must respect the cycle as it occurs. We believe the longer-term trajectory will produce positive growth, but we also recognize growth will be modest and the path volatile. Near-term economic indicators continue to point in the wrong direction, and valuations of risk assets are only modestly attractive. Further, market sentiment has yet to trough, re-enforcing our belief that a near-term defensive posture remains prudent until circumstances improve. Longer term, we recommend focusing on the middle of the risk spectrum, where we believe the best prospective risk-reward opportunities lie. This includes higher quality equities (with lower economic sensitivity); municipal, mortgage and corporate bonds (investment grade and selective high yield); global bonds (particularly emerging nations); and options-based and absolute-return strategies. Traditional portfolio allocations to Treasuries and higher-risk common stocks should continue to account for a portion of client portfolios, but we believe a lower-than normal allocation to these two extremes of the risk spectrum will enhance the prospective risk-reward profile of an overall portfolio.
