With roughly six months to go until the US expansion becomes the longest on record, there has been growing concern that the global economy more broadly is running on late-cycle fumes.
Lofty valuations, soaring profit margins, a flattening yield curve and a Federal Reserve tightening in the face of (admittedly muted) inflationary pressures — especially as the sugar high of fiscal stimulus appears to be wearing off — make an easy narrative. So much so that most analysts are already baking in the next recession.
But making the case that we are currently late cycle isn’t so straightforward. At the moment, different metrics are sending different signals.In order to determine whether or not the best is behind us, Pierre Lafourcade and Arend Kapteyn at UBS studied 120 different recessions across 40 countries over the past four decades to determine what happens before a business cycle peaks.
In tracking 14 different indicators around specific turning points and comparing the historical patterns against current data points coming out of the US, Eurozone and Japan (they didn’t have the data for China). Then, they created various butterfly charts which depict the behaviour of (or log of) the relevant indicators in the four quarters prior to and two quarters after these identified peaks in GDP growth. Then, they plot that against what’s happening in the US, Eurozone and Japan as recently as the second or third quarter of this year.
Unsure what a butterfly chart is? Well, hold on dear reader. You’ll soon find out.
The question their study answers, per Lafourcade: “Suppose we are on the cusp of a recession. What kind of data would we have expected to see over the past six quarters?” In other words, “does the current data behave differently from the data in the earlier late-cycles?” A caveat, though. Even if the current data matches up with the data around previous peaks, it does not necessarily mean that a recession is around the corner.
According to Lafourcade and Kapteyn, accelerating private consumption, investment growth and strides in productivity, among other gauges, suggest that the global economy is not yet late cycle.
First, private consumption. Typically ahead of a business cycle peak, this indicator falls, as indicated by the black line. Today’s data paints a different picture. For the better half of this year, US consumption has trended higher. In fact, consumer confidence, despite slipping slightly this month, still hovers near an 18-year high. Consumption in Japan and the Eurozone are likewise rising, although the pace is more moderate and has slowed down somewhat.
On the investment front, the US, Eurozone and Japan are also defying previous late-cycle trends. As measured by gross fixed capital formation (GFCF), investment tends to decline into a peak in GDP growth. Conversely, the US, Eurozone and Japan have seen investment tick higher in recent months.
Finally, productivity growth. In pre-recession periods, this indicator falls. That has most certainly been the case for Japan and the Eurozone this year, but for the US, the opposite is true. While productivity growth slowed in the third quarter, it’s up 1.3 per cent from the same time last year. While that is still quite sluggish, it’s at least expanding. So once again: evidence that the expansion is not in its later stages. Just yet.
Given these results, and considering how other indicators have fared, Lafourcade believes calls for a contraction are overhyped. “People are too certain that a recession will come in 2020,” he says.
But other data points allude to something more worrying.
For one, US housing prices have come down, as have auto sales. While David Page at AXA Investment Managers does concede that the global economy is giving off “mixed signals,” he says these trends in housing and auto sales are consistent with the late cycle.
Then, there’s the fiscal fade.
President Trump’s tax cuts and February’s spending package helped to nudge growth, but in the years to come, this material support underpinning the global economy is set to fade away. Right around the end of 2019.
By tracking the change in the cyclically-adjusted government balance from year to year, which Adam Cole at RBC Capital Markets says is a good proxy for discretionary fiscal expansion or contraction, he finds that the fiscal boost still has room to run. While the stimulus may be smaller in 2019, at 1.1 per cent of GDP versus 2.5 per cent, “it is still fiscal stimulus,” says Cole. Here’s his chart using OECD data:
Still, when it fades, so too will US growth.
Beyond the economy, George Gonclaves of Nomura says it’s not just the flattening yield curve (perhaps the most popular recession signal) that is pointing to the late cycle. Financial markets are as well. Take household net worth as a ratio of GDP and the total value of the S&P 500 as a percentage of GDP. Gonclaves points out that tracking the wealth effect from rising asset values says a lot about the business cycle. As his chart below shows, both of these ratios sit near record highs:
Here’s when these ratios at these levels start to look worrisome, per Gonclaves:
Now, these ratios do not need to signal the end, but unless GDP growth picks up further, usually these metrics adjust by declines in financial asset valuations (not the other way around).
What is more, he says:
Given that the last two recessions were in many ways a function of financial accidents gone awry it does concern us a bit that most of the risk market metrics are sitting at the high end of the percentile ranges.
That is concerning indeed.
Always remember that in the contemporary global economy, financial markets do not forecast the cycle, they make it.