Charlie Jamieson, Chief Investment Officer

Cycles are inevitable; certain patterns consistently reoccur. While the timing and specifics of each cycle vary and are vigorously debated in the moment, they often seem perfectly clear in hindsight, with the benefit of 20/20 vision.

We are now at a large junction where policy expectations will convert to actual policy delivery in US markets. The US Federal Reserve (US Fed) will commence a rate cutting cycle next week, joining the Bank of Canada, European Central Bank, Bank of England and Reserve Bank of New Zealand among others in lower borrowing costs. This opens the door for other nations to accelerate their own rate cutting cycles, as the relativity to the US policy rate is maintained. Rate cuts are being delivered because material inflation has been extinguished, US inflation will fall towards an expected 2.60% this week, whilst growth is losing momentum at a solid rate.

Despite comparisons to the Global Financial Crisis (GFC), there are reasons for optimism. Policymakers are more adept at handling financial issues, as seen with their swift response to the Silicon Valley Bank collapse. Tighter regulations have reduced systemic risks, and a large pool of capital, including $3.5 trillion in money market funds, is ready be deployed into a pullback. These factors are promising, though we might need to endure some challenges to achieve recovery.

In the lead up to the GFC, the US Fed raised interest rates from 1.00% in 2004 to 5.25% in 2006, holding them there until the economy stalled. The US Fed began cutting interest rates in September 2007, which initially boosted equities before the market peaked in October 2007, leading to a financial crisis. The parallels to today are striking, as the US Fed kicks off with cuts in September 2024 after a similar rate hike cycle to 5.25%, with the US economy now stalling and employment weakening.

We’ve long warned of the risks of policy “data dependency” – waiting for inflation victories that materialise well after growth momentum starts to slip, which is when policy adjustments are needed. Aside from the epic US government spending, the private sector has been in decay for some time.

As seen during the GFC, rate cuts alone can’t reverse an economy losing momentum. Leading into the crescendo that was Lehman Brothers’ ultimate collapse in September 2008, the US Fed had aggressively cut interest rates, slashing them from 5.25% to 3.00% in just four months, with a further 1.00% cut to 2.00% shortly after. Despite the 62% drop in funding costs, the lag effects of rate cuts failed to stop the downward spiral. Data dependency risks acting too late.

The economic cycle consists of four key phases: Boom, Slowdown, Recession and Recovery, which then leads back to another Boom – continuing the cycle.

Asset allocations can be dynamically adjusted to optimise performance during different phases of the cycle. With the recent loss of US employment momentum, are we moving from Slowdown to Recession? If so, improving asset quality and liquidity will be important to navigate the coming market environment.

Unlike the GFC, where systemic effects in credit creation destroyed confidence, proving that corporate credit was highly procyclical, this time private markets should break a lot of the systemic network effect elements, but pockets of pain in credit will persist. The good thing about public markets is they cleanse fast, take their medicine and re-set, while private markets lack the transparency to make problems easily identifiable, hiding issues and making workouts thereafter a drawn-out process.

The explosion of both private equity and private debt since the GFC has raised enormous capital and made significant returns in the Recovery and Boom part of the cycle but returns look likely to be far muted going forward through the Slowdown and Recession, whilst this capital may be locked up for long periods. Increased market volatility and reduced liquidity could make it harder to seize attractive opportunities if we transition into a Recession.

Markets have shifted focus from inflation concerns to growth anxiety. As a result, they will also likely move on from being highly return seeking to prioritising risk management. When risk markets start to falter, “return on capital” flips to “return of capital” very quickly, once broader risk markets start to wobble. In this environment, high quality fixed rate bonds with restored yields offer a clearer opportunity, especially now that majority of the Covid-induced inflation episode is behind us.

For investors, this means a shift in strategy is required ― a need to adopt a more defensive approach. Preserving capital will become a priority, with a focus on safer assets. The reduced inflation pressures provide an opportunity to lock in stable income, while limiting exposure to riskier, volatile assets. Diversification and liquidity management will be key to navigating this period.