Nicholas Rilley
The decade between the Global Financial Crisis and the COVID-19 crisis was characterised by China driving the global manufacturing cycle and the Federal Reserve driving the global monetary cycle. There was also the small matter of the euro crisis in 2011-2012, which saw European Central Bank President Mario Draghi’s convincing intervention that policymakers wouldn’t let markets force the breakup of the eurozone.
Consequently, measures such as China’s credit impulse have become popular for accessing the twists and turns of the economy cycle, while Federal Reserve policy remains under as much scrutiny as ever. However, there are compelling reasons as to why this cycle is very different to the last.
There has been some debate around whether the pandemic crash and recovery was the start of a new cycle, or whether the vast and swift policy response essentially ‘froze’ the last cycle in place.
This is an important starting point because, as the saying goes, if you want to know where you are going, it helps to know where you have been.
However, the challenge is the extent of the dispersion caused by the COVID-19 shock. Some sectors were beneficiaries of people staying at home and suffered no slowdown; in some instances business actually boomed. Whereas for other industries at the sharp end of social-distancing measures, there was a depression and economic activity temporarily went to zero.
Looking at aggregates is always challenging but it is particularly problematic this cycle because of the aforementioned underlying dispersion, which is quite different to the comparatively low economic volatility seen in the last cycle.
In the prior cycle, the services side of the economy grew consistently with little volatility, whereas the manufacturing cycle was more volatile and the marginal driver of cyclicality. The impact on commodities of China’s property slowdown in 2014 and the US shale crash of 2015 are prime examples.
However, the pandemic has caused huge volatility in the services sector – travel and leisure being at the forefront – so the backdrop now is very different.
The hope at the beginning of the year was that demand would shift back from goods to services; for example, fewer home improvements and more holidays. While this is happening to some degree, the pressure on the goods-producing side of the economy and the necessary logistics network have been more acute than many people expected.
This has created a situation where supply has become a more important factor than demand – a very different dynamic to the previous cycle, where demand was everything. The most important question was always, “Will households spend and will businesses invest?”, and this was partly why China was so important; as the West faced a triple whammy of deleveraging (households, banks and governments), China provided the balance sheet expansion that helped drive demand.
This backdrop of deleveraging during the last cycle is very different as households have been boosted by rising house prices, strong financial markets, government transfer payments and wage gains.
Meanwhile, the banking system has been incredibly resilient as impairments have been very low and governments are now looking at ways to build back better. Infrastructure spending in developed markets with a focus on the energy transition and climate change are important new cyclical drivers that didn’t exist coming out of the Global Financial Crisis.
Another notable difference between now and the last cycle is the inflation debate. The inflation scare in 2010-2011 proved transitory with the eurozone’s two rates rises being a costly error. This time around, there is a much more legitimate debate.
A decade of quantitative easing helped support financial markets but did next to nothing for the real economy. Governments running substantial budget deficits and sending stimulus cheques directly to households, on the other hand, is rocket fuel for the real economy.
Furthermore, this happened against a backdrop of a big shift in spending towards goods. Given that this happened at a time when the pandemic hit factory production, stressed labour supply and strained global supply chains, it is no surprise that we are hearing a lot from companies about inflationary pressures and, as a result, inflation expectations have jumped higher.
Historically, the combination of a slowdown in China, particularly one caused by a property and construction slowdown, together with incrementally tighter Federal Reserve policy and rising short-term US interest rates, would be very bad news for cyclical assets relative to defensive assets, and inflationary assets versus deflationary assets.
There are many economic crosscurrents and the uncertainty over the new Omicron variant introduces a new risk. However, since the summer, cyclicals have held up well and there has been more worry about inflation than deflation.
With the biggest economic shock in a generation causing the shortest-ever recession, it really is ‘different this time’. It is often said these are dangerous words in finance but in reality cycles do end for different reasons and new technological, economic or policy drivers emerge to kick-start the next economic cycle. It is important to focus on the new forces at play while also remembering that in one respect it is never different: human behaviour will always swing the risk pendulum between fear and greed.
Nicholas Rilley, CFA, is Investment Manager and Strategy Analyst at Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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