Where I Think We Are In The Business Cycle!

Date Added: October 23, 2018 | Comments Off on Where I Think We Are In The Business Cycle! | Filed under: Blog

Why avoiding a deeper financial crisis had a cost – and why a return to a more normal environment should be to our benefit

In the depths of the financial crisis, with the financial system at risk of going completely off the rails, monetary authorities (in the US: the Feds) tried to avoid a freezing of the financial system (which would have caused a collapse of the economy) first by lowering interest rates drastically and then, with interest rates at zero and that not being enough, by the Feds buying government and corporate assets in the market to directly inject new cash into it, to an extent never tried before.

The “artificial” condition of making available plenty of cash at low interest rates lasted for a decade and has only recently been curtailed as the global economy shows signs of resilience and an ability to stand on its own two feet.

As always, actions taken can have unintended or second order consequences. Artificially depressed interest rates had an impact on the valuation of assets as using a lower discount rate to calculate future cash flow streams makes those future cash flow streams appear more valuable. It also impacted behaviours in that low interest rates allowed for the building up of borrowings at very low carrying costs. The real estate bubbles in many developed countries were largely a consequence of these conditions. The technology bubble (2.0) was also in part a consequence being able to apply a low discount rate to evaluate the growth of future cash flows. The bull market in higher yield-offering securities (bonds, dividend paying stocks, etc.) was a result of “savers” looking for an alternative – in a desperate search for some yield – to the now low-yielding traditional products in which they would typically hold their savings, causing them to take more risks along on the risk continuum.

Now, with the cessation of these securities buying programmes, and an environment of rising interest rates, a dislocation and rotation is likely to take place as I recall happening in the 1987-1990 period and as I recall happening in the 2000-2007 period. In a normalized maturing economic environment (trade tensions aside) where economic activity has strengthened one might expect a rotation of capital away from those sectors propped up by low interest rates toward those sectors which benefit from economic growth and the potential for some inflationary pressures.

Coincident with the immediate post-financial crisis environment was the maturing of a commodities super cycle wherein capital available pre-financial crisis for the building of new sources of supply for many basic materials resulted in an increase in the supply of these very products just as demand dropped off in the post financial crisis economic weakness. Thus an era of imbalance in supply over demand ushered in depression-like conditions for the producers of many of these basic materials.

Through the process of time and the return and growth of demand in the normal course (and the fact that many of these new sources of supply were technically unable to perform at nameplate capacities), the demand supply balance for many of these producers has improved. With normalized economic growth now returning on a global basis (again – trade frictions aside), the strong possibility exists for reversion-to-mean type trades typical of the later stages of a traditional business cycle. This would draw capital from some of the “bubble” sectors which benefited from the “Great Monetary Easing” that we have experienced for the past decade toward those sectors which now benefit from economic growth and its accompanying demand for “stuff” particularly in those parts of the world still trying to build the infrastructure for a modern society (not to mention the beneficiaries of a post- modern/post- industrial society – where alternate sources of energy/ electric cars, etc are becoming increasing important).

Scott


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