The business cycle has been in the headlines recently. The cycle is usually seven years long and we are seven years in, so the idea that we are somehow doomed is getting traction. I disagree. Things will be different this time. Not better, but different, in a significant way.
So that we are on the same page – there are two drivers behind the traditional business cycle: inventory and credit. The inventory cycle is the key driver behind the seven-year cycle of economic growth that’s been with us since Biblical times. During bad times, buyers and manufacturers cut orders to reduce inventory. As things level out, their inventory has been depleted and so they order more than necessary, causing a pull-forward in demand for goods and services driving an economic recovery. So, industrial production and GDP don’t magically go up/down or “normalize”; instead, they are cyclically pulled by expectations and human error through the supply chain.
The second driver of the business cycle is credit. Credit cycles in the American experience are generational. There is a Biblical element here too – one generation saves, the second generation invests and the third generation squanders. It’s been so long since a credit cycle created problems for us that we have forgotten that they happen. Our current malaise is not new, but is the fourth credit cycle in our Nation’s history. The back-side of a credit cycle involves deleveraging, deflation and a generation of hard work to get the economy going again.
So how is this cycle different and how do we profit from it?
Here’s how I think about it. Imagine a pond. A willow branch sways across the water causing small ripples on the surface – these waves are the inventory cycle. A thicker, oak branch sways in the water causing deeper ripples across the surface – these waves are the credit cycle. As time passes, the ripples from the two branches sometimes overlap making higher-highs and lower-lows.
Now, a child enters the water and begins splashing about. This is the Federal Reserve. The child is playing a game – trying to push the water with its hand to offset the ripples coming from the branches. The inherent problem with this game is that the child’s waves can only offset the other ripples at one point in time (because of physics). As the energy from the child’s hand dissipates, it will flow through the water at a different frequency than the ripples from the branches – causing more, unexpected overlapping ripples across the pond the more time that passes.*
A recent example of this dynamic has been the Fed’s efforts to smooth the water directly in front of it by printing money. As we discussed back in 2009, the more time that passes, the more this approach will favor the returns on capital over returns on labor. Five years later, this effect is well understood and New York Times bestsellers have been written about it, but there are a myriad of other distortions already coming across the pond that are not yet at the top of investors’ minds.
The most timely example of such a distortion occurs as the Federal Reserve pulls back from printing money. Printing money helps asset prices grow faster than GDP. Asset prices are a key driver of consumption growth among the wealthy. Not surprisingly, about 60% of American consumption growth over the past five years has come from the wealthiest 20% as asset price growth has outstripped GDP growth. So as money printing slows and the unusual growth in asset prices slows – the most reasonable conclusion is that consumption growth will be negatively impacted. Without fuel, one would expect the engine of American consumption to sputter.
Reasonable and logical, yes. Expected, no. The earnings assumptions underpinning consumer and financial stocks are currently biased towards a recovery in consumption rather than a slowdown in growth. How could this be given the facts?
The argument for a recovery in American consumption growth is based on the inventory cycle. Historically, the inventory cycle has been the fuel driving consumption through capacity utilization and productivity gains.* This time is different. The pull-forward in inventory demand ended in 2010. It is now 2014. In the meantime, we have seen consumption growth driven primarily by asset appreciation impacting the behavior of the wealthy. So while the inventory/credit cycle are factors in consumption growth this business cycle, they have clearly been overwhelmed by the waves coming out of the Federal Reserve – both on the rise…and now on the fall.
The waves coming from the Federal Reserve are neither good nor bad. They are moving across the surface of the pond and are observable just as the inventory and credit cycle are. Having a child splashing about in the pond certainly does complicate things. But that is fine. These complications and distortions are the place where money should be made.
*The economy is more complex than the one pond. The better analogy would be many pond surfaces intersecting at different angles filled with fluids of different viscosity. So when the child pushes its hand through the water at one point, the energy dissipates and overlaps with other ripples in many dimensions. In simplifying this analogy, I have left out the impacts of investment and wages on consumption for another day.
THIS ARTICLE REPRESENTS THE VIEWS OF BISHOP ROCK CAPITAL, L.P. AND SHOULD NOT BE CONSIDERED A RECOMMENDATION TO PURCHASE OR SELL A PARTICULAR SECURITY.
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