What Late Cycle? The triumph of Goldilocks

 

Chief Economist's View

 

The first months of 2018 saw global financial markets roiled as the prospect of a faster-than-expected rise in US inflation and interest rates led investors to question whether the US economy was later in the economic cycle (i.e., closer to a downturn) than they had previously assumed. Investor fears were allayed somewhat in March as US labour market and price data showed that wage growth and inflation remain well contained. In fact, since the peak of the February panic, the S&P 500 has recovered by almost 6½% and US 10-year sovereign bond yields have slid by about 12 basis points and all is well in the world as the “late cycle” threat fades.

 

In this week’s Brief, we examine the current state of the global economic cycle. A typical economic cycle is characterised by four phases:

  1. a recovery phase, following a downturn or a recession, where excess capacity is being whittled away, unemployment rates are coming down, inflation is low, monetary policy is easy in support of the recovery, company earnings are recovering and investor risk appetite is returning leading to an expansion in P/E multiples;
  2. an expansion phase, where output gaps have closed, inflation is at central bank targets, the unemployment rate is at NAIRU, interest rates are at their long run averages as are company earnings and P/E multiples;
  3. a late cycle phase, where the economy has pushed into excess demand and the unemployment rate has slipped below NAIRU, inflation is exceeding central bank targets, cash rates have pushed above long run averages, growth is slowing, margin compression is slowing company earnings growth, investor risk appetite is waning and equity prices are correcting and the yield curve is inverting; and
  4. a recession phase, where economic growth stalls, excess capacity emerges, the unemployment rate rises, inflation falls, central banks ease monetary policy, equity prices fall, company earnings slide, risk premia spike, and P/E multiples collapse.

 

The current cycle, which for the US we trace back to June 2009 (the low point of the GFC), is now almost 9 years old. This makes the current cycle the second longest since WW2 and if it continues to June 2019, it will be the longest cycle since WW2. The sheer length of the cycle itself has led some commentators to assume we are either at, or close to late cycle. However, when we look at the factors that usually characterise a late cycle, we find a different picture. The main factor consistent with the late-cycle phase is the low levels of unemployment across most of the major economies including the US, UK, Japan and Germany. But as has been well documented, the usual relationship between the unemployment rate and wage growth/inflation has been disrupted over recent years, and therefore, the level of the unemployment rate has become a less reliable guide of the stage of the economic cycle over time.

 

Looking at other indicators of the economic cycle, such as output gaps, core inflation rates, cash rate levels, market inflation expectations and slope of the yield curve, the overwhelming evidence is that most economies are yet to peak and remain entrenched in the recovery phase of the cycle. Even in the US, core inflation and inflation expectations remain below the Fed’s target, cash rates are very low, and the yield curve remains strongly positive – all indicators of the recovery phase of the cycle. However, the US output gap has closed and is now switching from excess capacity to modest excess demand, and finally, equity valuations are now stretched with P/E multiples now significantly higher than long term averages. Our interpretation of the data is that the US is transitioning from the recovery phase to the expansion phase, which means it is still at least 18 months to two years from the late-cycle phase.

 

The benign settings for most of the late-cycle risk factors across the major economies, raises the possibility that the current cycle may avoid a late-cycle downturn and slide back into recession. A reason why this cycle may be different is that the exceptional length and gradual nature of the post-GFC global economic recovery has allowed major economies to address structural imbalances, such as: excessive debt levels; inadequate banking sector capitalisation; excessive bank exposure to public sector debt (in Europe); inflexible labour markets; and inadequate financial market regulatory environment.

 

The avoidance of late-cycle slowdown and slide into recession underpins the current consensus outlook for the global economy and financial markets - the Goldilocks scenario. In Goldilocks, the gradual nature of the recovery keeps underlying inflation from breaking out of central banks’ target bands. Hence, central banks normalise monetary policy, from the era of zero (or negative) interest rates and quantitative easing, in an orderly and gradual fashion. Central banks also have time to condition the market to higher cash rates and a reduction in liquidity injections. Consequently, risk asset valuations also correct in an orderly fashion. Hence, in Goldilocks, the main mechanisms driving the economy into a late cycle and recession – high inflation, high interest rates and a sharp correction in equity markets – are absent. So far, Goldilocks has proved extremely resilient.

 

Table 1: Financial market movements, 8 – 15 March 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,747.3

0.3%

US

2.83%

-2.9 bps

US Dollar Index (DXY)

90.14

0.0%

Nikkei 225

21,804.0

2.0%

Japan

0.05%

-0.8 bps

USD-JPY

106.34

0.1%

FTSE 100

7,139.8

-0.9%

UK

1.44%

-3.6 bps

GBP-USD

1.394

0.9%

DAX

12,345.6

-0.1%

Germany

0.58%

-5.2 bps

EUR-USD

1.231

-0.1%

S&P/ASX 200

5,920.9

-0.4%

Australia

2.71%

-9.7 bps

AUD-USD

0.780

0.1%

Source: Bloomberg

 

For economic update by region, click here.

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