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The big picture

Currencies and consumption are additional factors to consider in this “late-cycle” environment. But what could happen in the next investment cycle?

" What we really need to think about is the ’next normal’. "

Are you still focused on the four “Cs” – China, crude oil, credit markets and central banks?

I think these topics are still highly relevant, but they are not the only ones. In China, we have seen some encouraging recent output data – but risks remain. One thing of particular concern here is the credit boom within the Chinese financial sector. Looking briefly at the second “C” – crude oil – prices have been moving higher, due largely to fears about supply outages, but getting global supply and demand into balance is going to take some time and periods of volatility are certain. Higher oil prices may have reduced credit markets’ concerns about the U.S. high-yield energy sector for now – but the risk of defaults remains. And you don’t need me to tell you that the fourth “C” – central banks – is still the fulcrum around which everything else revolves. Their actions remain of central importance to all of us.

Would you now add currencies to this list?

I hate to get stuck on one letter of the alphabet but yes – you certainly need to add this extra “C”. Recent U.S.-dollar weakness has probably helped the global economy – through removing one headwind to commodity-price recovery and assisting emerging-market recovery. It has also given the Fed more room to hike rates, should it decide to do so – and we still expect two rate hikes over the next 12 months. It would, however, be unwise to assume that current trends will persist: we are likely to remain in a rather messy global currency regime for the foreseeable future, where reversals of trends are commonplace. Under this regime, we will remain concerned both about the implications of developed economies devaluing their own currencies (perhaps to avoid the more difficult challenge of structural reforms) and also about the likely response of emerging economies – most obviously China. The devaluation game is not one that everyone can win.

Are you expecting changes to the global currency regime?

No, I think that we have to learn to live with current uncertainty. History suggests currency regimes only change when they are forced to by real crises in the global economy or in markets. I know that the G20 will meet in Shanghai in September and there has been talk of a “Shanghai Accord” to give some structure and stability to the foreign-exchange markets, as the previous “Plaza” and “Louvre” Accords attempted to do. But I don’t think that we will find ourselves in a sufficiently bad situation in September to force change. A few years down the road, we might.

Can consumption continue to pull the global economy forward?

There is a view, often-repeated, that the continued enthusiasm of consumers to consume will carry us through any short-term downturn in investment or output. In the United States, this belief has found support from rising real wages and employment levels, together with positive wealth effects from a recovering housing market. But, again, do not assume that such trends will always continue. In Europe, consumer debt appears to be moving back up towards pre-crisis levels and at some point this will not be sustainable. So my answer to this question is “yes” but not forever.

So where do we go from here?

To bring in yet another “C”, we are now late in the investment cycle. In this “late-cycle” world, the focus will remain on corporate earnings – on downward revisions, when earnings are likely to find a bottom and broader issues of how we should interpret them. But being “late cycle” also means that we need to start to anticipate what could happen the next cycle, and here we return again to central banks and what they are likely to do next. A few years ago, investors were talking about a “return to normal”. Recently this has been replaced by discussion of the need to accept the “new normal”. But what we really need to think about is the “next normal”. What happens in the next cycle, for example, if inflation goes up, central banks have to jack up interest rates in response – and economies turn down? Are we forced back to further quantitative easing (QE) or something different? The only certainty is that we are not going back to a pre-2008 monetary-policy world anytime soon.

How should investors approach the current environment?

I am tempted to use another “C” word – “contrarian” – but this doesn’t quite capture what I want to say. I don’t think that you necessarily want to take long-term positions which go against market beliefs. But you do need to be prepared to go where necessary against shorter-term market trends – in a disciplined but flexible way. When markets appear to be still going up, you may need to consider when to sell; conversely, when markets are falling, you need to be alert to opportunities. This may not be easy – investors will have to overcome a number of built-in behavioral biases – but I do believe that this is the way to sustain returns in a difficult environment where sitting back is not really an option. Perhaps take reassurance from the musical term “contrapuntal” – different musical tunes or patterns, played together with discipline, can still create harmony.

Currency regimes: never a perfect solution

  • The end of the Bretton Woods currency regime in 1973 was followed by a series of agreements and accords which attempted to restore some order to markets. These included the 1985 “Plaza Accord” which had the intention of lowering the value of the U.S. dollar against other major currencies. But the size of the subsequent U.S.-dollar slide caused concern, prompting the 1987 “Louvre Accord” designed to put on the brakes. Currency regimes rarely work exactly to plan.

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