M&G's Isaacs: Economic Cycle Still Has Further to Run

Ten years on from the global financial crisis, some fear an economic downturn is imminent, but M&G's Stefan Isaacs sees no imminent risk of a recession

David Brenchley 21 September, 2018 | 2:49PM
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US Federal Reserve, US economy, economic growth, recession, debt, corporate debt, bond market

There’s no reason why the near-record-breaking economic cycle won’t continue to run well into the future, according M&G’s Stefan Isaacs.

The current expansion is now the second-longest since the end of World War Two. However, 2017’s synchronicity of global growth has made way for a year-to-date that has been driven by one region: the United States.

The positive impact of the Donald Trump administration’s tax stimulus combined with a buoyant stock market and booming consumer and business confidence has led to the US’s outperformance, at the detriment of the rest of the world, which continues to slow.

But Trump’s tax cuts could only be short-term in their stimulus nature, and therefore investors should expect the US to slow at some point.

Isaacs, manager of the Morningstar Bronze Rated M&G European Corporate Bond fund, say his clients “seem obsessively focused on the risks to the downside”.

Taking a balanced view, he does not see any obvious imbalances that may cause a downturn in the near term. “It is interesting to me that we have been talking about the end of the cycle for at least five years now,” he says.

“Everyone knows the adage about cycles not ending of old age and being caused by imbalances and central bank responses to those imbalances.

“If we look for those imbalances, personally we don’t see them in a significant way; not in a way that would suggest that central banks globally need to perhaps run aggressively against the tide of those imbalances and potentially cause the very slowdown that we’re fearing.

“I would argue, albeit I accept that it is very difficult to predict, that despite being the second-longest economic cycle on record in the post-World War Two period we still have time to run.”

Will the Tax Cut Boost Last?

Talib Sheikh, manager of the newly launched Jupiter Flexible Income fund, says at least some of the sugar rush the US economy has undoubtedly been on post tax cuts is likely to fade going into 2019.

However, economic data continues to be robust, unemployment is a 44-year lows and productivity has begun to increase. “I think it is premature to suggest we go into Q1 and the economy falls off a cliff because that fiscal stimulus has been unwound,” Sheikh says.

“The reality is that economies do have momentum and the US economy continues to have momentum. The US economy is also relatively insulated, with 74% of US GDP being related to consumption. That leads to outperformance, in my opinion.”

But James Vokins, co-manager of the Aviva Strategic Bond fund, does pose the possibility that we’re seeing “peak fundamentals” right now, though “that doesn’t necessarily mean something’s around the corner”.

He does think the Fed needs to be “incredibly careful” with its tightening programme, as going too quickly could pose problems for both emerging markets and credit. “They need to be wary it doesn’t manifest into a bigger economic problem,” he adds.

Potential Imbalances and Central Bank Responses

While Isaacs, who also manages the Bronze Rated M&G Global High Yield Bond fund, sees few imbalances around at the moment, there are a couple of places where excesses may have been built recently.

Those are the US high-yield market and the leveraged loan market. “A lot of capital has moved into that space… which suggests that the risk/reward there looks skewed to the downside to me,” he explains.

Leveraged loans have become a popular asset in this environment because they have minimal interest rate duration, meaning they are viewed as a good investment in times of rising interest rates. High-yield bonds also tend to outperform in rising rate cycles.

Sheikh’s new fund has approximately a third in US high yield, as he believes the economic conditions across the pond suggest default rates are likely to remain relatively low. He does worry that debt levels in the US corporate sector is high, though.

Elsewhere, Vokins sees “amber to red warning signs flashing” in both the autos and real estate credit markets. The former is starting to show signs of weakness after a very sustained uptick. The latter has seen huge growth in the issuance debt in public markets, he explains.

If something were to strike unexpectedly – and, it is worth noting recessions are rarely clearly signposted beforehand – how might central banks respond?

Isaacs notes that some economies have more levers than others in the case of a downturn. Indeed, the US Federal Reserve is much further down the rate rising cycle than others. The 0.25% increase expected next week will take the Fed Funds Rate to 2%-2.25%, with further rises to come.

The Bank of England’s Base Rate, meanwhile, is currently at 0.75% and we’re not due to hit 1% until May 2019. In Europe, meanwhile, rates are at zero and aren’t expected to be moved by the European Central Bank until the summer of 2019 at the earliest.

Isaacs agrees with many that quantitative easing is now “considered almost a standard response to easing policy”. That’s because “it seems pretty unlikely that the ECB is going to have hundreds of basis points of easing through its re-financing rate by the time we hit the next economic downturn”.

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David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk