Identify Through-Cycle Themes
One way of dealing with cyclical investment challenges is to look for investments whose performance is not primarily determined by the business cycle, or whose dynamics supersede or “look through” that cycle.
When we consider emerging markets, on the one hand we are dealing with an asset class that appears highly leveraged to the business cycle because of its importance in global supply chains and its sensitivity to the U.S. dollar. On the other hand, emerging markets are also navigating their own mega-cycles, which are not only generating structurally higher growth, but also actively changing their relationships with macro risks and the global business cycle.
Their populations are fast becoming the world’s consumers, not just its producers. They are balancing growth driven by commodities and low-value manufacturing with growth driven by consumption and high technology. And since the balance-of-payments crises of the late 1990s and early 2000s, many have adopted fiscal, monetary-policy, economic and financial reforms that have reduced deficits, balanced current accounts, built foreign-exchange reserves, tamed inflation, floated exchange rates and replaced billions of dollar-denominated liabilities with local-currency debt.
Should China’s stimulus measures fail to gain traction or the U.S. dollar continue to strengthen, neither would be positive for emerging markets. But it is also the case that emerging economies are now better able to absorb such stresses through exchange rates rather than through the large rate hikes, punishing current account adjustments and deep internal devaluations of the past. Indeed, we have already seen these structural, through-cycle reform programs protect emerging markets’ positive growth differential during the 2008-09 financial crisis.
There are many other places to look for similar long-term investment themes. Some, such as mitigating the impact of climate change, represent both vast challenges to society and billions of dollars’ worth of growth-investment potential. Others, such as Big Data, artificial intelligence or 5G connectivity, have the potential to drive change in almost every part of our lives in perhaps unimaginable ways.
The advantages of these thematic investments, in terms of diversifying away from the business cycle, are twofold. First, they can be sources of resilient earnings growth during a period of widespread earnings deterioration; and second, investments that are leveraged to particular themes are often subject to idiosyncratic volatility, driven by newsflow around the theme rather than, say, the strength of the U.S. dollar or manufacturing PMIs.
Of course, investors who look through cycles too blithely can get sucked into bubbles—particularly during the later stages of a cycle. It is worth remembering that the dotcom bubble had its origins in the avoidance of a U.S. recession in 1998, when the Federal Reserve responded to a downturn in global demand and a series of emerging markets crises with three rate cuts: the resulting relief grew into market exuberance that soon over-ran the reality of corporate earnings.
Still, considering how the list of the world’s 10 biggest companies have changed over the past decade should remind us of two important things. Amazon did not become bigger than Walmart or Johnson & Johnson simply because it has navigated this business cycle more efficiently or aggressively, but more because it has been instrumental in changing the way our economy works. And the top four, which are all technology companies, are survivors of the dotcom bubble.