The Market Cycles Are Changing

The recession marking the end of the era of consumer discretionary has been painful. Like all things, good and bad, it too shall come to an end. The question is what next? Economic cycles are rational. Late contractions start with a recovery in financial services and information technology; the economic expansions which follow are driven by consumer discretionary, industrials, basic materials and energy; then comes the time for defensive sectors such as health care, staples, utilities & telecom, which gain popularity during contractions.

No one can deny that since the devil's low of 666; financials, information technology and discretionary have tried to tell us that the next cyclical expansion might soon begin; they have outperformed. It might be a false reversible outperformance, but for now outperformance it is; and it is coming at a time when the future while far from bright, is looking less dark. The expansion, whenever it starts, is very important; it marks the onset of a new economic cycle lasting typically 6 to 7 years. This one is even more important because it marks the end of a secular trend in financials and discretionary sectors; this secular change-over is a significant event occurring no more than once each 18 to 20 years. This particular secular age, is even more important, for it marks the end of a group of 3 distinct secular cycles (financials, information technology & discretionary; basic materials, industrials & energy; health care, staples & utilities and telecom) - a once in 60 year event.

The economic cycle is simple, it is rational, and it rarely varies other than in sector intensity. Predicting the outperformers for the next several market cycles is important; for this is what dictates the intensity within the sectors; financials, information technology and discretionary may well signal the impending start of the next cyclical expansion, but it is highly unlikely they shall lead the next bull.

The leader of the next bull needs a secular story, not a cyclical one and the secular expansion of the financials & discretionary sector is done. Both financial and consumer balance sheets are in agony; de-leveraging is necessary and de-leveraging will take time. Assume that the $50 trillion peak property market could support debt of $40 trillion. A fall in property values of 40% from peak to trough indicates new asset values of $30 trillion; that supports sustainable debt levels of $24 trillion. The $16 trillion debt gap is the extent of de-leveraging necessary and it will play out over many years; some will be written off, some is over-estimated as it goes without saying that not all consumer debt was created at peak property values, some will reduce as debt gets serviced and paid down by borrowers, some will disappear as sustainable debt levels rise once property prices start rising sometime in the future. While this process unfolds, both financial institutions and consumer balance sheets remain at risk; they cannot lead on a secular basis, so who will?

It is my view that the past decade and a half saw great strength in financial services, information technology and consumer discretionary. That era has drawn to a close. The era now starting has several very visible pointers. America needs to restore financial discipline, to de-leverage, to save more, and to restore its primacy as a producer. So financial services as a multi-market cycle leader is out. Consumer discretionary is out too. Information technology will remain important because it plays an important role for all economic sectors; but it is no longer a secular star. Who will be the next secular winner?

Industrials, basic materials and energy have all had a strong past economic cycles. I expect this group to see strong outperformance on a multi-market secular cycle basis. The rise in the US savings rate will mean lower demand for discretionary goods. The hard lessons now learned will change habits for well over a decade. These savings will be invested, for what is saved must be invested; you can either consume it, or save it, and if it is saved, it is invested. Even if it simply deposited in a bank, it will be invested since a deposit gives the bank access to cheap capital to lend. And yes, what is saved can also be used for paying for past consumption; de-leveraging consumer debt is what I expect most savings to go towards initially. Do keep in mind that as savings rise and de-leveraging continues, balance sheets get repaired and result in an increasing ability to expand credit; particularly with the kind of monetary stimulus in the system.

Capital will be needed for investment in industry to restore America's lost producer status; energy demand will elevate as industrial production rises and before industrial production rises, basic materials will be necessary. Without raw materials, industrial growth is but an illusion. The strength in this sector has strong secular support from China and India; both economies with huge industrial and infrastructural needs. These are capital intensive sectors (both extraction and capacity expansion require high levels of capex and opex) and availability of credit in a de-leveraging economy is tight. Yet, the demand fundamentals together with supply constraints will mean strong cash flows. This coupled with the massive monetary stimulus will mean incremental credit flows to the sectors. Much will come from debt diversion from prior popular credit markets (the consumer) to these sectors.

For financial investors, commodities provide a high degree of interest during periods when elevated inflation is expected, and more so when a dollar devaluation is possible. In my view, the large monetary stimulus injected into the global economies the world over will prove inflationary for the consumer and will result in a weakening dollar as risk aversion reduces with time.

While there is no doubt that extensive de-leveraging will be necessary following the recent and ongoing collapse in asset prices, it must be noted that deflation & de-leveraging do not always go hand in glove. Take for example the last 15 years; we have seen low levels of consumer price inflation, together with high asset price gains. Now it is likely that high consumer price inflation will come with restrained (not absent) asset price gains. The commodities area will no doubt have subdued asset price increase because the speculative premium caused by financial investors will be absent. Yet, do bear in mind that asset prices will rebound strongly from where they are today once demand re-surfaces - the speculative premium makes for a small part of the total price increase witnessed prior to the crash, not all of it.

For an investor, Australia, Canada, Brazil and Russia provide compelling basic material and energy opportunities. West Africa (Angola, Equatorial Guinea, Nigeria) all provide strong energy plays - these are best entered via the oil majors. These countries all have secular bull themes. China and India provide strong industrial and infrastructure opportunities and shall remain in secular bull formation.

Within the United States, strong outperformance in industrials, energy and basic materials can be expected. United States corporations remain amongst the best in the world in terms of access to capital, ability to create intellectual property, access to equipment and access to talented management - this is a huge competitive advantage. These corporations can and will succeed in a globalized world despite a potentially subdued home market.

In terms of capital structure, today leveraged entities are shunned. They also offer some excellent valuations. Look at Arcelor Mittal (MT) or Rio Tinto (RTP). Both are excellent companies with the ability to generate long term cash flows to service and pay down existing debt levels. Both have the ability to dispose non- core assets, cut costs, capex and dividends to pay down debt. While leveraged companies are shunned by equity investors, the debt investor interest in corporate debt is rising; Arcelor Mittal has already taken advantage of this to change its debt maturity. Both are capable of raising equity to pay down debt and yet being under-valued post dilution – this extreme step (new equity) could be an option if this period of dis-location continues for an additional two years (2009 & 2010). In a future period of inflation, debt embedded in the capital structure can be powerful as the value of debt falls in real terms.

All in all, leveraged entities are valued with risks priced and then some. Shun the leveraged players if you have a high conviction of deflation going ahead; shun them if you do not see long term cash flows to service and pay down debt, but do not shun them simply because debt is unpopular today – remember that interest in the corporate debt market comes from investors traditionally more conservative compared with equity investors – today interest in corporate debt is rapidly rising - tomorrow it will spread to equity investors.

Disclosure: Author is long RTP, BHP, MT, AAUK, RIO, BP, SLB, NOV, RIG, CAT, DE, SI, INTC, NOK, DELL.