Cycle kilter, qu’est-ce que c’est?

Official news came last week that the US recession caused by COVID-19 lasted only two months, making it the shortest in the country’s history.

Tim highlighted earlier in the year that the pandemic had helped reset the US economic cycle, and Emiel noted in our latest quarterly outlook that the current cycle might be unusually compressed as we appear to have gone from early to mid-cycle within 12 months.

We believe early identification of potential paths for both fundamentals and market narratives is vital for asset allocators, from both a return and a risk perspective. To complement some of our other risk-management techniques – such as those focused more on volatility metrics or factor exposure – we also undertake scenario analysis.

In broad terms, there are three approaches to such exercises: focusing on asset-class stress tests, modelling against historical episodes (assessing how the current portfolio would have fared if events such as the global financial crisis or the COVID-19 induced panic in markets in March 2020 recurred), or forward-looking economic scenarios.

We’re going to concentrate on the latter category in this blog. We start the process by debating scenarios which we think have a reasonable chance of occurring over the coming year (tail-risk scenarios are discussed in a separate forum), before assigning estimated probabilities of occurrence and thinking about market implications under those scenarios. We can then use this matrix of information to assess portfolios’ likely performance, while continuing to monitor and evolve the scenarios as time goes on.

So how does our latest scenario analysis look?

And plotted against growth and inflation axes:

Both our most likely scenario of a healthy recovery and the weighted average scenario suggest above-trend growth and inflation modestly above target.

There is also a mild positivity among investors generally that is hard to shift: yields are low, policy conditions are generally supportive, and inflation – although high – is not seen as problematic. The vaccine story is also generally encouraging, although we remain aware of the risks.

However, we think the positive sentiment is pretty well priced by markets too, so return expectations shouldn’t be too lavish from here if that scenario plays out. The upside is a ‘Roaring 20s’ type recovery; the downside is a COVID-19 variant or vaccine failure inducing a deflationary slump or rapid cycle compression, although neither attracts a particularly high probability in our view.

It’s fine to be in the crowd of this consensus positive outlook for a while – indeed, some of us may look forward to being in actual crowds again – but as investors we don’t want to stay there for too long. Consensus thinking can be dangerous.