Yes, Virginia, There is a Business Cycle

© STRATEGIC ASSET ALLIANCE, INC. Document not to be reproduced without the explicit consent of SAA.

Yes, Virginia, There is a Business Cycle

March 28, 2019 Alton Cogert Daniel Smereck Nathan Simon

President & CEO Managing Director & Principal Financial Analyst

© STRATEGIC ASSET ALLIANCE, INC. Document not to be reproduced without the explicit consent of SAA.

I. Historical Business Cycle

II. Last Four Economic Cycles

III. Latest Economic Thinking

IV. It’s a Small World

V. How Are Insurers Reacting?

VI. What About Your Insurer or Risk Pool?

Overview

The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. 2

The Economic Cycle

• SAA BOTTOMLINE: Late-stage economic cycle characteristics are showing in varying degrees across the world’s largest economies: 1) rising inflation; 2) tighter central bank policy 3) less credit availability, and 4) shrinking profit margins. While the debate regarding prospective expectations and implications ensues, all these factors are in play and will have fundamental roles in shifting and shaping investor sentiment during 2019. While the world’s major economies continue to diverge and global momentum slows, China remains the real wild card given its own slowing economic growth (6.5% officially and slowest pace since 2009), debt levels, and the potential impact of a protracted US/China trade war. Depending on the depth of any Chinese economic weakness, China’s economic struggles could export more volatility to other parts of the world.

Source: Wilbanks, Smith & Thomas & SAA

The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed.

Historical Real GDP Growth Rates

3Source: NERB

-10.0

-5.0

0.0

5.0

10.0

15.0

U.S. Real GDP Trends Over Time

GDP Quarterly Change (%) 10 Year Moving Average (%) 10 Year Moving Standard Deviation (%)

➢ Mean and standard deviation declining

➢ Lower reward and risk from fiscal and monetary policy decisions,

maturing economy and workforce


Longer, Lower Growth Expansions

4Source: BEA, NBER, J.P. Morgan Asset Management

➢ JPMAM expects longer, lower growth expansions and shorter, shallower

recessions

II. THE LAST FOUR CYCLES

5


S&P 500 Returns v GDP Growth Rates

Source: STL Fred


CPI-U v GDP Growth Rates

Source: STL Fred


BBB Spreads v GDP Growth Rates

Source: STL Fred


Global Copper and Gold Prices

Source: STL Fred


Copper/Gold Ratio v GDP Growth Rates

Source: STL Fred


10 Year-UST v GDP Growth Rates

Source: STL Fred

10Y-3Mo UST (No Lag to GDP)

Source: STL Fred


10Y-3Mo (1 Year Lag to GDP)

Source: STL Fred


10Y-3Mo (2 Year Lag to GDP)

Source: STL Fred


"While the 3-month to 10-year spread “has a relatively decent track record of predicting recessions, it suffers from a

timing problem,” said TD Securities U.S. rates strategist Gennadiy Goldberg. “Its inversion can suggest a recession

occurred six months ago or will occur two years from now.”

https://www.bloomberg.com/news/articles/2019-03-22/u-s-treasury-yield-curve-inverts-for-first-time-since-2007?srnd=premium


What Is The State Of The Economy?

Source: Russell Investments


GDP Missed Expectations

III. LATEST ECONOMIC THINKING

25


➢ Did not predict Great Financial Recession

➢ Many measures tied to ‘old economy’ measures

o GDP – what is the impact on GDP of having over 100k worth of tools in your pocket (cell phone) at no ‘marginal cost’? Zero

o Tech revolution means less capital needed for a given amount of economic activity – another item not reflected in GDP

o CPI – adjusts for technological improvements, but how accurate is that?

➢ Assumes ‘rationality’ and does not take into account behavioral impacts – important when trying to determine the right policy mix

26

Traditional Economic Thought is Flawed


➢ Still uncertain as to what would successfully replace traditional economic thought….

27

No Certain Replacement

Source: The Limits To Growth; 1972


➢ Still uncertain as to what would successfully replace traditional economic thought, which has implications for problems like:

o The growth of debt, especially government debt

28



Growth of Debt? Especially Government Debt…

Source: CBO, BEA, Treasury Department, J.P. Morgan




o What is the correct size for central bank balance sheets?

30



What is Correct Size for Central Bank Balance Sheets?

Source: J.P. Morgan Asset Management

• The world’s central banks are, in aggregate, reducing their balance sheets (i.e. tightening monetary policy) with the U.S. leading the way. The world’s economies have been accustomed (or addicted) to loose monetary policy for an extended period. With the monetary tightening beginning in earnest during 2017 (again with the US leading the way), the world’s economies are adapting (or in recovery). As these source of economic stimulus are slowly removed from the system, how will tighter credit affect consumption, business investment, and sentiment (i.e. GDP growth expectations).





o Aging demographics (fewer people to pay for social services)

32



Aging Demographics – United States

Source: World Bank, St. Louis Fed Reserve

➢ Age dependency ratio, old, is the ratio of older dependents (people older than 64) to the working-age population (those ages 15-64)


Aging Demographics – United States: Part 2

Source: US Census Bureau


Aging Demographics – Global Example: China

Source: US Census International Database

•China’s current median age: 35.6 years•China’s median age in 2030: 41.1 years (close to Europe today)•China’s median age in 2050: 45.2 years (close to Japan today)

•Worth Noting: North America’s median age is currently 37.5 years, 5% older than China’s current reading. By 2050 projections have it at 42.1 years, 7% younger than China’s population.





o Aging demographics (fewer people to pay for social services)

o Need for fewer current workers due to tech revolution (e.g. AV and all of its first and second order impacts)

o What to do with untrained workers, laid off due to tech revolution?

36


IV. IT’S A SMALL WORLD

37


➢ As global economy grows at a greater rate than US rate, the US becomes a smaller portion of global GDP

38

It’s a Small World

Source: IMF.org


➢ New number one: likely China, but as a developing economy they are subject to much more volatility

➢ What does this mean for the reserve currency status of US ‘in the future’?

39

It’s a Small World - Part.2

V. HOW ARE INSURERS REACTING?

40


Greatest Concern: Risk of Economic Slowdown

Source: GSAM Insurance Asset Management Insurance Survey 2018


Investment Opportunities are Getting Worse



Portfolio Adjustments Over The Next 12 Months


• Most will:

o Decrease equity and credit risk

o Reduce Duration

o Increase Liquidity


➢ Insurers have continued confidence in growth-related asset classes

o i.e. private equity, emerging market equities and US equities

➢ Many plan to decrease allocations to high-yield debt, tax-exempt municipal bonds and US equities

➢ Increases expected in allocations to less liquid assets

o i.e. infrastructure debt, commercial mortgage loans and middle market corporate loans

➢ ESG Consideration continues to grow

44

Additional Asset Class Thoughts


VI. WHAT ABOUT YOUR COMPANY OR RISK POOL?

45


➢ Strategic v Tactical discussion

o Any tactical decision must be made within overall strategic decisions

➢ Understand your Manager’s opinions on the economy

o Typically the consensus

➢ Understand your Manager’s opinions on where the best investment opportunities are given their thoughts on the economy

o Consistency check

➢ Compare their opinions to what other Managers are saying

46

What About Your Company or Risk Pool?


Which way are managers leaning?

Source: Public Statements from Various Investment Managers

“We do not currently see investor or corporate behavior that could be considered “excessive” or giving rise to a “bubble.”… This expansion phase will end one day, but it won’t pass because of old age.”

“…we are starting to see signs that a recession may finally be on its way. Interest rates are on the rise, and the U.S. Treasury yield curve is flatter… we are beginning to make changes to our strategies to prepare for the end of the cycle.”

“Our Recession Risk Dashboard still signals

economic expansion, but faster wage growth has

moved that indicator from green to yellow, due to

potential pressure on corporate margins.”

“We see a mid-cycle slowdown, but upside on the horizon.”

“The objective probability of a recession in the next 12 months remains low by late-cycle standards…This, however, could be as good as it gets. To be clear, we are not outright bearish, but equally we struggle to see the catalysts to build meaningful upside momentum… While the economic outlook is neither hot nor cold, Goldilocks it isn’t.”

Uncertain Times ahead

Further Expansion


The Economic Cycle

• SAA BOTTOMLINE: Late-stage economic cycle characteristics are showing in varying degrees across the world’s largest economies: 1) rising inflation; 2) tighter central bank policy 3) less credit availability, and 4) shrinking profit margins. While the debate regarding prospective expectations and implications ensues, all these factors are in play and will have fundamental roles in shifting and shaping investor sentiment during 2019. While the world’s major economies continue to diverge and global momentum slows, China remains the real wild card given its own slowing economic growth (6.5% officially and slowest pace since 2009), debt levels, and the potential impact of a protracted US/China trade war. Depending on the depth of any Chinese economic weakness, China’s economic struggles could export more volatility to other parts of the world.

Source: Wilbanks, Smith & Thomas & SAA

Economic Cycle: Where Do You Think We Are?

= Group Average

= Min

= Max

= Median = Mode

Yes, Virginia, There is a Business Cycle

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