By Jim Allworth
A big majority of economists polled see the U.S. economy in the “late cycle” stage. We agree—the U.S. economy and likely the Canadian and British economies are in the late stages of what will probably go down as the longest-ever economic expansion, measuring from the end of the Great Recession in mid-2009.
Eric Lascelles, chief economist at RBC Global Asset Management, Inc., assigns scores to 17 different factors as to where they are in their normal cyclical progression (see table). Overwhelmingly the majority are giving readings typical of the “late” or “end” of cycle. But importantly none are behaving as if the U.S. were already in recession.
The term “late cycle” has an aura of “living on borrowed time” about it. However, the U.S. economy is not yet “that late” in the late cycle. We closely monitor six indicators that have done a good job over many cycles of warning that a U.S. recession was on the way or about to start. None of these is currently signalling that any such economic downturn is as yet nearby.
Three of the six—the shape of the yield curve (i.e., the gap between short- and long-term interest rates); the trend in unemployment insurance claims; and the year-over-year rate of change in the Conference Board’s Leading Economic Index—have all typically given an advance warning of an impending recession 9–12 months ahead of time. None are currently flashing any such warning and it is our assessment that it will be some time before they do.
U.S. business cycle scorecard
Source - RBC Global Asset Management
This suggests GDP, corporate earnings, and share values all have room to advance further for some time yet. We expect all these things will also be true for the economies and markets of Canada, the U.K., the eurozone, and Japan.
That said, it’s worth checking in on investor mentality today. Clearly, things are very different from what they were in the early part of the cycle. From the time the recession ended in mid-2009 all the way through 2014, “risk aversion” was the dominant psychology. Banks all around the world were rebuilding capital, were unsure about the condition of other banks, and were cautious about lending.
Despite a powerful recovery in share prices off the bear market lows and price-to-earnings (P/E) multiples that were at levels indicating above-average future returns, most individuals remained “reluctant investors.” Very little, if any, money flowed toward equity funds, but there were massive inflows into bond funds where returns were unusually meagre.
Skepticism prevailed. In the U.S., despite the economy regaining all its lost ground and posting new highs by early 2011, consumer and business confidence readings remained low for another three-and-a-half years.
Today that skepticism, that had lingered for so long, has been replaced by elevated confidence on many fronts. Consumer confidence in the U.S. is at historically high levels while it is at or not far off cycle highs in Europe, Canada, and Japan. Business confidence could also be characterised as buoyant. In the U.S., an unusually high fraction of small and medium-sized businesses, surveyed by the National Federation of Independent Business, rate this a “good time to expand.”
This elevated confidence reflects current conditions—GDP growth is running above trend and has become largely self-sustaining; labour markets are tight in the biggest developed economies, job security is high, and wages are growing; real estate values are elevated; and monetary policies are moving closer to normal.
The stock market, retrenching through much of this year, seems to be out of step with these elevated confidence readings. In our view, that’s because equity markets paid in advance for today’s more buoyant conditions. Stocks moved up from depressed lows in 2015, through 2016 and 2017, to much higher levels and more expensive valuations by early 2018. But when investors looked forward to 2019 and 2020, a somewhat more challenging view emerged. In the U.S. the additive impact of corporate tax cuts will begin to wane as year-over-year earnings comparisons become much less vigorous. Earnings estimates for next year are already being revised downward, albeit from very high levels. Overall, the massive fiscal stimulus delivered by federal tax cuts and increased spending should diminish over 2019 and turn into a modest drag in 2020.
Stimulus measures everywhere, with the exception of China, are expected to have a diminished impact on growth. Add in a possible first rate hike and the end of quantitative easing by the European Central Bank, a further bank rate increase by the Bank of England, two, possibly three more hikes from the Fed, and the same from the Bank of Canada, and it sounds very much like “late cycle” to us.
Major economic indicators still in expansion mode
RBC Wealth Management U.S. economic indicator scorecard
No U.S. recession in sight so far.
Source - RBC Wealth Management, Bloomberg, FRED Economic Data St. Louis Fed
We think the appropriate posture for managing an equity portfolio at this juncture in the late cycle is one of “leaning against risk.” We are moving our recommended equity exposure in a global portfolio down to Market Weight from a modest Overweight. While at some point a more significant reduction in equity exposure will be appropriate, we don’t think that time has arrived. But below are some things that should be on the agenda for the coming year:
Value over growth
Growth stocks have led the market for much of the last nine years. The ability to post solid revenue and earnings gains plus widening margins over a stretch when the economy was mostly growing at an anemic, below-trend pace attracted an ever-growing investor following. Now, over several quarters, the economic background has shifted in a way that is more supportive of value—GDP growth is above trend, inflation is rising, as is the 10-year yield—while growth P/Es are more stretched relative to those of the value segment than at any time since 2005. A high proportion of growth stocks are found in the technology, consumer discretionary, communication services, and biomedical sectors. More than half of the value component resides in financials, energy, consumer staples, and parts of health care.
Large caps over small caps
Small-cap stocks typically begin to underperform well before the broad market peaks, and fare worse than large caps in a bear market. Small caps have noticeably underperformed in the recent selloff. We do not expect them to resume leadership in what remains of this bull market.
Focus on dividends
Over a full market cycle, dividend payers outperform non-dividend payers and especially dividend cutters. And dividend growers have historically done the best of all. Much but not all of this outperformance typically arrives during bear markets. We believe the focus should be on a company’s capability to pay, sustain, and grow its dividend out of cash flow generated by the business. Very often a closer examination of companies that offer a high dividend yield reveals they pay out a very high proportion of their earnings as dividends, are often also buying back shares, and may be borrowing and building up leverage to do so. In an economic downturn this combination can be problematic, in our view.
Identify high operating leverage to GDP
Some companies—many industrials, consumer cyclicals, and commodity cyclicals—enjoy strong revenue growth, widening margins, and robust earnings gains when GDP growth is running above trend. That is often the case in the late cycle. But when the economy slows or dips into recession this dynamic can shift into reverse, often quite painfully. We believe these stocks/groups should be high on the list for cutting when the time comes for defense.
Pay attention to relative strength
Relative outperformance by a stock or group can persist for a considerable time. Often a high proportion of stocks that do better than the market in one year go on to do better the following year as well. And when that trend breaks down it can sometimes usher in an uncomfortably long period of underperformance. Keeping in touch with how a stock is doing relative to its group and to the broad market is a very useful element of portfolio due diligence.
Non-U.S. Analyst Disclosure: Jim Allworth, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.