The U.S. economy is now in its tenth year of expansion and, at 36 quarters, is within two quarters of being the second-longest on record. “Late cycle” is a term heard frequently these days to suggest the end of this amazing streak is near. Late cycle carries a negative connotation, suggesting a recession is approaching, bringing with it potentially dire consequences for investors.
In our view, a sole focus on the time elapsed for this expansion is misplaced. Economic cycles don’t simply die of old age. And, based upon the key indicators we monitor, the current cycle likely has room to run—at least several quarters, perhaps even years.
Darkest before the dawn
The current expansion began as the Great Recession ended; the official start date was June 2009. The Fed had lowered interest rates to zero percent the previous December, 10-year Treasury yields were close to four percent, and the S&P 500 was sitting at 926.12. In hindsight, it is easy to see how the start of the current extended cycle might have been missed as most investors were intently preoccupied with aftershocks from the global financial crisis.
This is a long-lasting but slow-growing recovery
% U.S. cumulative GDP growth during each recovery cycle since WWII (years represent beginning of recovery)
Number of quarters each recovery lasted
Source - RBC Wealth Management, Federal Reserve Bank of St. Louis; quarterly data through 7/27/18
Furthermore, over the past 10 years economic growth has been far from robust, averaging just 2.2 percent—well below the 3.3 percent long-term average—hardly enough to make anyone overly exuberant. In retrospect, though, this long period of slow growth may have been just what was needed following the carnage wrought by the Great Recession and the unwinding of the unsustainable imbalances that led up to it.
Where do we stand?
Of the four phases of an economic cycle—early, middle, late, and recession—each brings its own implications for markets and investment portfolios.
Clearly the economy has moved past the early stage, which is typically characterized by a change from negative to positive growth, sometimes very rapidly as an economy rebounds from a recession, usually propelled by both monetary and fiscal stimulus as well as pent-up demand. Furthermore, it is safe to say the economy isn’t in recession today, even though throughout the nine years of this expansion a recession has been the bogeyman many have felt was always lurking just around the corner.
So that leaves us with trying to determine whether we are in the middle or late stage of the current cycle, with the former meaning that risky assets, like equities and corporate bonds, have more time to run, and the latter that rallies in risky assets should be more closely monitored for signs of deterioration.
As mentioned earlier, the easy, consensus call is “late cycle,” but as with many things it may not be as clear-cut as that. Analysts have been making the late-cycle call for at least two years, even though this is a stage in the economic cycle that has a typical lifespan of approximately 18 months.
Many of the late-cycle calls that abound today seem to be more dependent upon “elapsed time” than on supporting economic data. For perspective, it is generally assumed that in the middle phase of a cycle the economy gathers momentum assisted by an accommodative monetary policy stance. This phase is typically the longest. Once the economy actually rolls into the late-cycle stage, signs of overheating are becoming apparent, inflation pressures are building, and monetary policy can be characterized as tight or restrictive.
Yield differential between the U.S. 10-year Treasury note and the 1-year note
Arrows indicate points where the yield curve inverted
Source - RBC Wealth Management, Federal Reserve Bank of St. Louis; data through 8/1/18
It appears the economy is currently straddling two stages of the economic cycle, which makes the analysis more challenging.
Two “mids” before a recession?
The broad characteristics for the middle and late stages of a cycle are both evident today. This expansion has been characterized by long periods of slow growth. Yet GDP for the just-completed Q2 came in at a brisk 4.2 percent, the fastest pace in four years, largely a result of the fiscal stimulus provided by tax reform measures passed in late 2017. Whether this is a “one and done” result remains to be seen, but as things stand, RBC Capital Markets forecasts annual growth for this year and next to average three percent—above the sluggish trend rate but still not overheated by most measures.
We know the Fed has a two percent target for inflation, but only recently has its favored measure, core personal consumption expenditures (PCE), matched this number. Meanwhile, policymakers have yet to express any concerns about building price pressures. Unemployment recently touched 3.8 percent, its lowest level since the 1960s, but at the same time has failed to produce a surge in wage pressure. Finally, even after seven rate hikes since December 2015, Fed policy still cannot be classified as restrictive. The idea of a “neutral rate” for fed funds, where policy would be deemed neither tight nor loose, is a topic of debate by the Federal Open Market Committee. Policymakers are uncertain as to the exact level of the neutral rate; estimates vary across a range from 2.25 percent–3.00 percent, but most Fed officials believe it to be around 2.75 percent. Hence, at current levels, fed funds are only three quarter-point rate hikes away from neutral.
Phases of the economic cycle
Source - RBC Wealth Management
Global Portfolio Advisory Committee economic indicator scorecard
Unanimous readings consistent with the economic expansion having further to run.
Source - RBC Global Portfolio Advisory Committee
The point to be made here is that by looking at these measures it is hard to say with confidence in which stage the economy is currently positioned—it still exhibits both mid- and late-cycle characteristics.
So, arguing for the mid-cycle assessment, growth has been speeding up to an above-trend pace closer to three percent; inflation seems contained and, in any case, isn’t yet bothering the Fed; while monetary policy remains accommodative and credit conditions benign.
Turning to the late-cycle side of the ledger, growth may be peaking—most forecasts (including our own) have it subsiding somewhat next year and further in 2020; inflation has been moving up, not down, and extreme tightness in the labor market together with very little excess capacity left in the economy suggest price pressures could build from here; and, finally, the Fed is committed to further rate hikes, and its own “dot plot” (which captures the Fed’s forecasts for the path of future rate hikes) suggests the fed funds rate will reach or surpass the neutral rate next year.
There must be more
With so much noise surrounding this issue, it would be useful to have some guideposts to mark the economy’s transition from one phase of the cycle to the next.
Eric Lascelles, chief economist for RBC Global Asset Management, recently released his latest quarterly business cycle review, which tracks 17 different factors that exhibit different behaviors at different stages of the cycle. His assessment is that the U.S. economy is displaying late-cycle characteristics that suggest the economy has one to two years before the current business cycle ends. His analysis cites the “absence of economic slack, big job gains, a long run up in equities, a high level of confidence, and a few wobbles in the credit space.”
Our scorecard of a half-dozen forward-looking economic indicators, shown in the table above, gives unanimous readings consistent with the economic expansion having further to run. So all in, even though mid- to late-cycle indicators are elevated, we believe recession risks remain low for now. This is notable because recessions have always been associated with equity bear markets and a challenging time for some parts of the fixed income market.
End of tightening cycle in sight according to market pricing
The futures market is pricing in just three more rate hikes versus six from the Fed.
Source - RBC Wealth Management, Bloomberg, Federal Reserve; data through 8/27/18
The current environment, which features fast-changing trade disputes, the imposition of tariffs, uneven growth across various regions, and geopolitical concerns, poses a number of challenges for the global economy. The question, in our view, is not so much whether any one or all of these would cause the U.S. economy to dip into a recession, but whether they might accelerate the economy’s path through the cycle lifespan.
So far, the answer has been “no.” The U.S. economy has displayed a high degree of resiliency in recent years as economic performance was unaffected by events in China in late 2015 and Brexit in 2016. For the most part, the same can be said for all the developed economies and many emerging ones as well.
It is likely the U.S. economy will be able to withstand the challenges posed by trade disputes, but these could, depending upon their duration, push the U.S. economic data more decisively into the late-cycle column. Unresolved, these disputes could make the next recession more challenging when it eventually arrives.
The Fed could tip the scale
The timing of any economic downturn puts the focus squarely on Fed policy. Credit that is more difficult to come by and too expensive has typically been the factor that has tipped the U.S. economy into a slowdown and recession.
To date, the Fed’s policy actions have been referred to as “normalization” or “quantitative tightening,” essentially removing the excess stimulus put in place in response to the Great Recession, not restrictive monetary policy. However, in our view, policy could be nearing an inflection point: after seven rate hikes the Fed’s “dots” suggest policymakers are only halfway through the current tightening cycle, while market expectations—with which we agree—suggest only three more hikes are warranted.
If the Fed pursues the more aggressive path it laid out in the spring, this could turn policy restrictive sometime next year, driving the weight of the evidence even more fully into the late-cycle column. It would also legitimize, for the first time in this cycle, discussions about a recession being on the horizon.
Timing is always everything
As has been the case for some considerable time, the U.S. economy is exhibiting both mid- and late-cycle characteristics. Gradually the evidence for a late-cycle interpretation has become predominant. We think that will go on being the case until credit conditions become restrictive enough to make a recession inevitable, but it is important to remember that “late cycle” doesn’t mean “end of cycle.”
So far, monetary conditions have not reached that level of tightness and are unlikely to reach such a point before next year, perhaps beyond. Once “tight money” arrives it is typically a year or so before a recession gets underway. But so-called risk assets can begin to suffer well ahead of the recession start date.
In our view, it is too early to become aggressively defensive with respect to either equities or fixed income. But thinking ahead of time about what such eventual defensive positioning would look like is always appropriate and highly recommended.