Affordable cost of capital – globally – underpins this bull market

By Samy Chaar, Chief Economist

This economic cycle has further to go is an oft-heard cautionary refrain these days. That the recovery began eight years ago is indisputable – but one should not forget that it was initially confined to the US. Europe suffered an extremely severe sovereign debt crisis in 2011-2012, while the vicious four-year down cycle in emerging markets ended only mid-2016.

So, really, it is only in the US that the recovery is long in the tooth. European earnings just recently started to recover, with economic dynamics now firmly in positive territory. As for the emerging world, the interrelated trends of falling commodity prices, weaker currencies, imported inflation and a rising cost of capital finally all stabilised 18 months ago, enabling a reversal of the negative macro spiral into a virtuous one.
 

Indeed, as regards cycle longevity, the only question that should be asked is whether we remain in an environment that will enable companies to generate sustained profits – be it in the US, in Europe, or across the emerging world. Our simple answer, looking both at economic trends and financial conditions is yes.

It is admittedly easy to draw up a scenario under which these economic and financial conditions deteriorate, driving down corporate margins and profits. But this would first require a pick-up in wages and inflation, forcing central banks to accelerate their tightening of monetary policy. And not only is no deterioration perceptible for the time being, but the concrete realisation of such a sequence would take time before becoming truly detrimental to economies and financial markets.

Also, one should be careful to keep a disciplined approach in measuring current conditions, particularly financial. The coming reduction of the Federal Reserve (Fed) balance sheet is widely – and rightly – viewed as a tightening factor. Less discussed is the fact that it will be taking place after a 10% fall in the value of the US dollar, a typical loosening factor. Overall, despite two rate hikes (perhaps a third in the making) and the announced balance sheet contraction, financial conditions have actually eased in the US this year. Put differently, greenback depreciation has allowed economic conditions to remain stable, maintaining the overall profitability of the corporate sector.

With employment still robust, inflation contained, liquidity available and relatively affordable across most of the western and emerging world, we would thus argue that this economic cycle has further to go. Until we see clear signs of overheating and/or deterioration of financial conditions, which would be a leading indicator of an eventual struggle in the corporate sector, we intend to keep our risk-on portfolio positioning, favouring US credit, European equities, emerging debt in local currency as well as emerging market equities.

Note: Unless otherwise stated, all data mentioned in this publication is based on the following sources: Datastream, Bloomberg, Lombard Odier calculation.