Our view is that this leisurely journey could continue for some time. Assessing the market landscape, we anticipate the current business cycle could last another five years or more. Part of our reasoning is that we believe, contrary to popular wisdom, that the credit cycle drives the business cycle. With this in mind, it’s worth considering where we are headed.
Strong Credit Fundamentals
There are two key components to the credit cycle, and both are encouraging right now. The first is the price of credit, which is driven by the U.S. Federal Reserve (Fed). The second is the availability of credit, which is driven by banks. The Fed recently indicated it would take a pause on raising rates, a wise decision in our view, given that U.S. economic growth is slowing. At the same time, lending standards remain high, with demand for loans still strong and manageable.
A deterioration in credit fundamentals would be a leading indicator for the end of the business cycle, but we see no such signs. That suggests this prolonged cycle still has room to run.
What Could Go Wrong?
As managers who are always mindful of risk, we routinely ask, “What could go wrong?” We see two main scenarios that could derail the current cycle: a Fed policy mistake or a geopolitical crisis.
As the oft-quoted line from MIT economist Rudi Dornbusch rightly observes, “None of the post-war expansions died of old age. They were all murdered by the Fed.” We think the same principle could apply to this market, especially given the outsized role the Fed has played throughout this current expansion.
With a growing but slowing U.S. economy, momentum is likely to moderate this year and so far the Fed has remained responsive to this. While the latter stages of a cycle are often the time when policy mistakes occur, we are encouraged by how attuned central banks around the globe have been to slowing growth.
Nevertheless, in today’s globalized world, geopolitical events can have outsized impacts. Although Brexit negotiations are stalled, global trade rhetoric has ratcheted back, and the U.S. and China seem to be moving closer to a deal. While this has reassured investors, a reversal could prove damaging to sentiment, and any larger geopolitical event would likely have a more significant impact on markets.
Even if these risks do not materialize, however, investors would be wise to remember that volatility typically increases in the later stages of the business cycle. We certainly saw that in December.
What’s the Right Path for You?
Over the past decade, investors in need of income have been forced to veer further out on the risk spectrum to seek to generate adequate yield. With interest rates still historically low, and likely to remain range-bound, the quest for yield is undiminished. Yet maintaining the same approach at this point in the cycle could leave portfolios overexposed to risk when volatility strikes.
As equities experience periods of episodic volatility toward the latter stages of the cycle, the diversification benefits of fixed income become more important. Diversification is typically what provides a smoother ride over time.
Yet deviating away from the traditional role of fixed income (providing downside mitigation and diversification from equities) by incorporating sectors with the potential for higher yields could result in fixed income allocations not providing the portfolio stability investors expect. As seen in Exhibit 1, investment-grade debt is uniquely positioned to offer portfolio stability, as it has historically provided attractive income without sacrificing capital preservation.
Are You Ready for Any Rough Terrain?
Now may be an opportune time for investors and advisors to review portfolios and ensure that they can handle any difficult roads ahead.
Given the prospect of higher volatility, it's important to examine fixed income holdings and understand the risks embedded in your portfolio. Take a close look under the hood to make sure allocations are in line with clients’ risk tolerances and ability to withstand volatility.
As you re-evaluate current fixed income holdings, beware of any unintended equity-like risks. In particular, assess the risk/reward tradeoff of exposures to the following historically higher-yielding areas of the market that may be unable to serve as adequate diversification to equities:
- Emerging market debt
- High-yield debt
- Higher duration, with greater exposure to interest rate risk
Consider repositioning your fixed income allocation to prepare for the road ahead by incorporating investment-grade debt or increasing an existing allocation. Relative to other fixed income sectors, investment-grade debt can potentially help investors de-risk portfolios and still seek to earn attractive yields. With that added ballast, investors’ portfolios may be ready to handle whatever unexpected bumps or sharp curves the stock market presents.
The mention of specific countries, securities, or sectors does not constitute a recommendation on behalf of OFI Global.
Debt securities may be subject to interest rate risk, duration risk, credit risk, credit spread risk, extension risk, reinvestment risk, prepayment risk and event risk. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future will cause the values of a portfolio’s investments to decline. When interest rates rise, bond prices generally fall, and the value of the portfolio can fall. Extension risk is the risk that an increase in interest rates could cause prepayments on a debt security to occur at a slower rate than expected. Below-investment-grade (“high yield” or "junk") bonds are more at risk of default and are subject to liquidity risk. Diversification does not guarantee profit or protect against loss.