How much runway is left for the U.S. expansion?
The U.S. expansion is over eight years old, and the S&P 500® Index is up almost 300 percent, cumulatively, from the bottom in 2009.1 This is the second longest bull market in modern history and the third longest economic expansion in records dating back to the 1800s. History would suggest that now is not the time to be complacent. After all, recessions almost always bring bear markets. And so, after such a strong and long run, it’s important for investors to take a step back and think about where we are in the cycle.
Full disclosure: forecasting recessions is very difficult. But we can, and do monitor the risk factors that suggest when an economy is becoming more vulnerable to a major setback. In practice, recession monitoring is usually a blend of two very distinct approaches.
A contrarian approach: macroeconomic imbalances
“Too much of a good thing can be a bad thing.” — William Dudley, 1999
The first method is predicated on an understanding of recessions for what they are—a natural (but very painful) healing process in which the economy clears the imbalances that accumulated during the good growth years. In 2015, Janet Yellen quipped that expansions don’t “die of old age”. That’s technically correct—expansions don’t die of old age—but in our view they do die of something loosely related to the age of the expansion: accumulated imbalances.
Because the Great Financial Crisis was so severe, it has taken a long time for the U.S. economy to get back to normal again. But by many measures we’re already there now. Consider the following:
- The U.S. unemployment rate is at its lowest level in 17 years2;
- Broader measures of labor market slack (e.g. the “U6 rate”) match the lows in the prior expansion3; and
- The Federal Reserve’s (FRB/US) model suggests the economy has moved slightly beyond its potential.
And so, when we look at the economy today, the biggest risk factor appears to be the labor market, which is already on the cusp of overheating. As demand for workers outstrips the available supply of labors, companies are forced to raise wages to attract the best talent to work at their firm. If companies are able to pass that wage inflation on to consumers, we’ll likely see faster price inflation and a faster Fed hiking process that eventually “takes the punch bowl away”.
If companies can’t pass that wage inflation on to consumers, we’ll likely see a compression in corporate profit margins. Neither bodes well for the duration of the cycle. Admittedly, every cycle is different. 2009 cleared excess leverage in the housing market; 2001 cleared years of over-investment in information technology. The list goes on. We’re probably not in the danger zone yet, but our analysis suggests that these labor market risks will start to become amplified in 2019.
Alert level: amber
A confirming approach: looking for evidence of a slowdown
The second approach is to look for evidence that the economy is slowing—high frequency indicators of consumption growth, employment growth, business investment, and the behavior of asset prices all give us a pulse on how the economy is performing in real-time. By design, these indicators are best in determining recession risks in the very short-run.
Our Business Cycle Index (BCI) is a fairly sophisticated econometric model that captures many of these insights in a mosaic way. The BCI currently suggests the probability of a U.S. recession over the next year is about 25 percent. That’s nearly double the long-term average—knowing nothing about current macro conditions, an investor should assume the risk of recession in any given year is about 14 percent. Bottom line: we believe near-term recession risks are slowly rising, which is also suggestive that we are getting later in the cycle. Importantly, we usually don’t get too agitated about this model until the probabilities move north of 30 percent. We’re not there yet.
Alert level: amber
Other risk factors
The three factors that we will be watching the closest in the U.S. over the next few years are wage growth, the slope of the yield curve and when Fed policy becomes outright restrictive.
Wage growth is important as a transmission mechanism of a strong labor market into inflation or corporate margin pressures.
The yield curve has historically been one of the single-best predictors—inverting before each of the last 5 U.S. recessions. It is becoming very flat today, with just a 70 basis point spread remaining between the 10-year and 2-year bond yield. In other words, if the long-end holds steady, the yield curve could invert after just three more Fed hikes. The Fed’s forward guidance suggests we’ll be there by 2018.
And on a related note is the stance of Fed policy. Many investors might conclude that a 1% fed funds rate is still historically low and therefore very accommodative. However, there’s mounting evidence that the “neutral” policy rate is much lower than where it was in the past—perhaps even below 2%. There’s considerable uncertainty around these estimates, but again there’s a risk that Fed policy could shift into a restrictive mode in late 2018 or 2019, which is another risk factor we’d look for toward the end of the cycle.
Risk factors outside the U.S.
Most of our discussion so far has been centered around the U.S. economy. This was a deliberate choice for two reasons:
- The U.S. economy is very large (remember the saying “when the U.S. sneezes the rest of the world catches a cold”), and more importantly;
- The U.S. expansion is arguably the most mature after over eight years of uninterrupted growth (contrasted with Europe, which experienced a double dip recession).
China is another large market that has our attention as a potential downside catalyst. Admittedly, growth in China and the broader emerging markets has been impressive since the middle of 2016. This itself isn’t the concern, but rather the fact that the private sector in China has become more and more indebted in recent years. Debt-fueled growth isn’t sustainable—and Zhou Xiaochuan, Governor of the People’s Bank of China, recently warned that latent risks are “hidden, complex, sudden, contagious and hazardous”. Timing the end of a debt cycle can be very challenging, but we see this as an important medium-term risk factor, given the important role that China plays as an engine of growth in the Asia-Pacific region.
In short, we’re entering the later innings of the economic cycle, but we believe a global recession does not appear imminent. This creates a challenging environment for investors to generate returns when many assets are already expensive. Our central scenario looks for subdued global equity market returns and modestly higher bond yields as the cycle grinds on for a few more years.
In this environment, we think a multi-asset approach brings the requisite flexibility to seek out returns where they exist. Specifically, non-U.S. markets are an area likely to offer more upside potential in the next few years, given their stronger cyclical fundamentals and relatively attractive valuations.
Risks to our central scenario are two-sided. Strong growth, low inflation, and a patient Fed could drive a blow-off rally in markets—pushing an expensive U.S. market even further into expensive territory. We also run the risk of a Fed policy mistake. There’s significant uncertainty around where the neutral rate is today. The fact that we are seeing low inflation and modest growth against a 1% fed funds rate suggests that the current policy might not actually be that accommodative. If the Fed hikes more aggressively into this environment, they could damage the economy more quickly than many are forecasting. A major fiscal policy disappointment could also be cause for a setback in consumer and business confidence.
1 Source: https://fred.stlouisfed.org/series/SP500. Date range: March 1, 2009-Oct. 31, 2017