Did we skip a phase or two in this investment and economic cycle? It looks like we did, and investors should notice what happened. Indeed, a typical investment and economic cycle has four main phases. There’s peak growth, which is followed by a decline. The decline ends in a trough, which is followed by a new period of growth.
We definitely hit and then went past the peak in the last quarter of 2018 with slowing growth and a falling stock market. Normally, this would be followed by a decline that would turn into a recession.
Now, it looks like the decline was small. A recession was avoided or, at least, postponed.
The Fed often triggers the cycle. As the growth phase continues and inflation starts to rise, the Fed increases interest rates and tightens the money supply to reduce inflation. The Fed usually over-reacts and doesn’t reverse its tightening until the economy is in a recession. Then, the Fed reduces rates and increases the money supply, restarting the cycle.
This time the Fed reversed its policy before the economy entered a recession. The stock market declined in the fourth quarter of 2018 and other factors scared Fed officials so much that they reversed policy almost overnight.
Now, because of changes at the Fed and in the economy that I’ve talked about over the last few months in retirement watch and my Spotlight Series, a recession could be delayed for some time.
In the post-financial crisis period, we never had a period of exuberant growth. As a result, inflation hasn’t established momentum. The Fed and other central banks are far more worried about another recession than about rising inflation. They’re not going to tighten monetary policy for some time.
But lasting effects from the financial crisis prevent the strong economic growth, speculation and excess lending that usually accompany a period of very low interest rates and easy monetary policy. The result is that we might avoid the extremes of boom and recession for a while. Instead, I think we’re likely in for a continuation of this period of low growth and low inflation.
That doesn’t mean smooth sailing for investors. Investment markets since 2009 have been supported primarily by money from the Fed and other central banks, plus very low interest rates. Those factors enabled investors to push up the prices of stocks with very little risk. Stock prices increased far more than the economy and earnings and now have high valuations.
Don’t expect similar results going forward. Central bank policies will be less effective than in the last 10 years, as the central bankers have made clear. Stock prices are more likely to change in line with earnings and the economy. Stocks could decline if earnings growth is below inflated expectations. Less effective central banks add a level of risk to the economy. Future growth will depend more on fiscal policy, and that requires government officials to work effectively together.
Of course, there are risks other than monetary and fiscal policy.
Trade conflicts between the United States and other nations, especially China, make the global economy more fragile. The United States and China signed a trade agreement, but few of the substantive issues were settled.
China has issues to deal with outside of trade. Economic growth is much lower than at its peak and falling. China’s economic health influences the global economy and especially most of the other Asian economies.
Europe and Japan remain risks. Japan still hasn’t recovered from its long depression. Europe remains on the edge of a depression and is in political turmoil.
There also are risks from outside the economy and markets, what economists call exogenous risks, some of which I discuss in Portfolio Watch.
Because of these and other risks, I continue to recommend you maintain a margin of safety in your investments and have a balanced portfolio.