Most fund managers like to say that they focus on buying good companies and then holding them for a long time irrespective of economic conditions. Still, it’s impossible to get away from the fact that the economic cycle does have an effect on valuations, as investors found out the hard way during the bear markets of 2000-02 and 2007-09.
One person who uses economic cycles as a core part of her investment strategy is Julie Dean, who runs the TM Sanditon UK Fund. We profiled her in more depth earlier this year, but suffice it to say that she’s got a very good record – quadrupling investors’ money between 2002 and 2014 at her previous employer.
The end of the bull market
Dean’s basic view is that “the recent better relative performance of stocks in defensive sectors is one sign that the structural bull market is coming to an end”. Another indication comes from weak survey data, especially the PMI surveys which measure firms’ expectations about whether business is speeding up or slowing down. The UK manufacturing PMI is at a three-month low, while the Chinese figure is at the lowest level it has been for nearly eight months.
Although the US data remains strong, the forward indicators are beginning to soften. Certainly, much of the breakneck American growth is due to the fiscal stimulus provided by the Trump tax cuts, rather than due to any underlying strength.
In any case, while the Trump tax cuts may have succeeded in delivering a short-term boost, they might end up bringing the problem to a head by forcing the Federal Reserve to start raising interest rates. Although Federal Reserve chief Jerome Powell’s hawkish interest rate policy may have angered Trump, the president is behaving like a hypocrite “by blaming Powell for cleaning up the mess created by his fiscal policy”, says Dean. Despite this pressure, she expects the Fed chair to “stand firm”, especially since “the labour market is incredibly tight at the moment, which “always happens in the late stages of the economic cycle”.
Rising rates are a particular problem, because many companies and countries remain highly indebted. According to some measures, “global debt to GDP is as high as it was during the financial crisis”. Higher interest rates are causing particular pain in countries such as Turkey, which has an estimated $500bn of external debt, hence the plummeting Turkish lira and stock market.
However, Turkey isn’t the only loser, since “much less attention has been paid to the fact that the Chinese yuan has lost all its gain versus the dollar over the past 18 months”. The dramatic falls in cryptocurrencies are further indications we are moving into a “cyclical bear market”.
What should you do?
So, what should you do? In Dean’s view your response depends on your time horizons. For those looking to make a quick profit, it might be worth making some bets on a “tactical bounce” as “there is a good chance of a rally if things don’t get as worse as quickly as people think”. She’s taken advantage of the recent fall in emerging markets to buy shares in Ashmore, an emerging market fund manager, which has fallen 20% from its peak at the start of the year, despite solid financials and an expanding business. However, such a strategy is, at best, a “temporary trade”.
For those focusing on the medium term, Dean recommends that you move towards defensive shares. Indeed, she notes that, “we have less than 15% of our UK portfolio in industrial, cyclical and financial companies”. In contrast, she notes that drug companies and supermarkets have done well recently, while telecoms might be another sector worth considering.
In terms of individual companies, she likes the outsourcing firm Capita (LSE: CPI), which has now being reorganised. She also think that the advertising firm WPP (LSE: WPP), which trades at 10.5 times earnings with a yield of 5%, and the share register company Equiniti (LSE: EQN), are worth considering.
Of course, the big question is whether any downturn could end up becoming a rout. While Dean is reluctant to make a definite prediction, she notes that there may be a lot of truth in the old stockmarket saying that, “stocks climb stairs, but go down in a lift”.
She also notes that the 2007-08 crash was only cushioned by unprecedented amounts of co-ordinated monetary action between the world’s major central banks. Given Trump’s “abrasive” personality, it is debatable whether investors should count on such international goodwill being summoned a second time.
Whatever happens, any downturn will almost certainly be especially bad news for “much loved” technology growth stocks, such as Tesla, Netflix and Ocado. Dean notes that the takeaway company Just Eat currently trades at 42.5 times current earnings. In her view, you’d certainly be better of holding cash than investing in those types of companies.