"BE FEARFUL WHEN OTHERS ARE GREEDY, AND GREEDY WHEN OTHERS ARE FEARFUL"

~Warren Buffett, Investor and Chairman and CEO of Berkshire Hathaway

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There is something captivating about the concept of cycles. They provide a sense of continuity, a natural rhythm in an otherwise chaotic world. The idea of cyclicality is deeply embedded in economic theory, from the invisible hand restoring equilibrium after supply-demand imbalances, to the cost of capital shaping our propensity to innovate. Cycles have a natural tendency to revert to the mean, creating a predictable pattern that allows us to make sense of complex systems. Without these cycles, finance and economics would likely be chaos.

Economic cycles have long been studied by economists and investors as a way to understand the fluctuations in market conditions, credit availability, and technological progress. Two key cycles shaping the current global economy are the debt cycle and the innovation cycle. While distinct in their nature, these cycles are deeply intertwined, and their interaction is crucial to understanding the future direction of global growth and market behaviour.

The debt cycle is currently in a critical phase. Years of low interest rates and loose monetary policies have fuelled a surge in global debt, with governments, corporations, and households accumulating record-high levels of borrowing. As central banks shift to tighten monetary policy and combat inflation, the cost of servicing this debt has risen dramatically. According to Hyman Minsky’s Financial Instability Hypothesis, periods of stability encourage risk-taking and overleveraging, eventually culminating in financial crises. Minsky argued that stability breeds instability, a view echoed by Ray Dalio, who has described both short-term and long-term debt cycles. In Dalio's framework, the long-term debt cycle leads to crisis when economies are overburdened with unsustainable debt, forcing painful deleveraging processes.

Simultaneously, the innovation cycle is gaining momentum, driven by advancements in artificial intelligence, biotechnology, and clean energy. This cycle aligns with Nikolai Kondratiev’s theory of long-wave innovation cycles, also known as Kondratiev Waves, which suggest that major technological breakthroughs occur in waves and drive sustained periods of economic growth. Currently, AI and automation are at the forefront of this cycle, with new technologies transforming industries and creating new markets.

Joseph Schumpeter expanded on this concept with his theory of creative destruction, where innovation disrupts industries, making outdated business models obsolete and driving economic renewal. As technology reshapes sectors like manufacturing and energy, it promises increased productivity and new growth opportunities. However, the tension between these two cycles creates a complex landscape for investors and policymakers.

Innovation, while crucial for long-term growth, requires significant capital. The tightening of credit due to the debt cycle could hinder investment in research and development, slowing the pace of technological progress. As debt-servicing costs rise, businesses may find it harder to fund new projects, creating a potential drag on the innovation cycle.

On the other hand, innovation may provide the solution to a debt crisis. Nobel prize winner, Paul Romer’s Endogenous Growth Theory highlights how technological change and innovation, spurred by investments in knowledge and human capital, can drive sustained economic growth. Unlike traditional growth theories that treat technological progress as external to the economy, Romer’s work emphasizes that innovation is an internal process driven by intentional investment. In this context, AI-driven productivity gains have the potential to offset the negative effects of high debt levels by increasing efficiency and reducing costs, making it easier for businesses and governments to manage their financial obligations.

As interest rates cycle down once again, easing monetary conditions could support the next wave of R&D and capital expenditures, potentially unlocking new growth opportunities. But Schumpeter's question remains: how much creative destruction can economies withstand? The transition from old industries to new ones will take time, potentially leading to disruptions in labour markets and evermore wealth inequality. While innovation promises growth, the social and economic adjustments that follow could be painful.

Alas, as the global economy grapples with rising debt and rapid technological change, the interplay between the debt cycle and the innovation cycle will define the future of economic growth. Whether we see a financial crisis or a technological renaissance depends on how these opposing cycles evolve.

Despite the uncertainty, we believe a few things are certain:

- Investment opportunities have never been this attractive,

- The 60/40 narrative will face headwinds, and

- Active investors, driven by robust asset allocation and security selection insights, should flourish!

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