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Capital IdeasTM

Investment insights from Capital Group

Categories
Currencies
Downturn in the US financial cycle may be near
Jens Søndergaard
Currency Analyst
May 20, 2022
KEY TAKEAWAYS
  • The US financial cycle may be reaching a peak, underscoring concerns that the economy may be nearing a recession.
  • There have also been signs of a sharp downturn in the credit cycle in other developed markets.
  • Rising inflation, higher interest rates, a slowdown in China and the Russia-Ukraine conflict are all feeding the trend.

With the US Federal Reserve in a full-on fight against inflation, concerns are rising that tighter monetary policy could tip the US economy into a recession. A look at longer-term financial cycles underscores the risk.


I have studied financial cycles in the United States and around the world to gain a vantage point on the global economy and asset values that differs from the view that standard business cycles provide. Since I update my models on a periodic basis, my investment colleagues and some of our clients have asked what I think about the current US financial cycle.


My view is that it will peak later this year, much sooner than the late 2023 or early 2024 peak that I expected a year ago. A turn in the US financial cycle would be bad news for US economic growth in the medium term. Further, financial cycle peaks often precede periods of financial distress. This could spell trouble for highly leveraged areas of the US financial system, such as the riskiest corners of the high-yield (BB/Ba and below) bond market.


US financial cycle nears the peak1


downturn_in_the_us_financial_cycle_may_be_near

How financial cycles work


As a reminder, financial cycles are derived from trends in house prices and the amount of private-sector debt in an economy. Economists use house prices to gauge perceptions of value and risk, and the stock of private-sector debt as a harbinger of rising leverage in the financial system. The interplay between these factors can ultimately translate into economic booms and busts, and episodes of financial distress. For example, the last peak in the US financial cycle in 2006 — driven by soaring house prices and a surge of consumer debt — preceded the global financial crisis.


Financial cycles usually last much longer than business cycles, which track economic expansions and recessions. A good analogy is to think of financial cycles as seasons and business cycles as changing weather patterns.


There are four distinct phases of the financial cycle, corresponding to the trend of leverage in an economy. Turning points in financial cycles often coincide with changing fortunes for equity and bond markets. My analysis of more than 40 years of asset class returns shows that bonds tended to fare better than equities around financial cycle peaks, while equity returns were typically stronger around financial cycle troughs.


1. Sources: Capital Group, Bank for International Settlements, Organisation for Economic Co-operation and Development, National Institute of Economic and Social Research. Actual data as of the third quarter of 2021; forecast through the second quarter of 2026. Index, 1971 = 0. Financial cycle data incorporates home prices and the stock of private-sector debt in the economy. Figures on the Y axis provide a scale to illustrate the magnitude of fluctuations in the financial cycle.


 


Risk factors you should consider before investing:

  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
  • Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.

Jens Søndergaard is a currency analyst at Capital Group. He has 18 years of investment industry experience and has been with Capital Group for 11 years. Earlier in his career at Capital, he worked as an economist covering the Euro area and the UK. Prior to joining Capital, he was a senior European economist at Nomura, a senior economist at the Bank of England and an assistant professor at The Johns Hopkins University. He holds a PhD in economics and a master’s degree in foreign service from Georgetown University. Jens is based in London.

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