Discerning the key factors driving the current “late cycle” economy is a bit like following cycling team race strategies in the annual Tour de France. Everything is a bit nuanced and appears, at times, chaotic to the untrained observer.
Please indulge us as we celebrate the annual summer Grand Tour and apply a “Le Tour” metaphor to highlight the economic factors competing as the dominant ones in our current late-cycle economy.
First up is Team “Yield Curve”. The shape of the current U.S. Treasury yield curve is getting a lot of attention because it currently reflects the flattest slope since 2007. The difference in yield between the 10 and 2-year treasuries is around 25 basis points (.25%). Market wisdom suggests that if the yield differential between the long and shorter maturity treasuries goes negative, or inverts, then a recession is approaching.
Those who are searching for the finish line of the current economic cycle are carefully monitoring this metric. However, there are multiple drivers behind the yield of the 10-year treasury note. If one simply assesses the P/E ratio of the note relative to equity P/E’s, the implied valuation for the note suggests a 34 multiple (bond price divided by yield) while the trailing twelve-month P/E ratio for the S&P 500 is closer to 21. This metric would imply that bonds are expensive relative to equities which suggests that longer maturity yields could easily rise rather than invert if Fed tightening continues.
Team “Fed Tightening” is particularly tricky. Many economists believe that the Fed is tightening economic conditions with their rate increases which could bring an end to the current economic cycle. Indeed, the Federal Reserve has raised the overnight Fed Funds rate by 0.50% so far this year to 2.0% and has signaled its intention to raise rates to 3.5% by 2020. Is this real tightening? Our current economy is growing at an annualized nominal rate closer to 4.8% which would imply real GDP growth of approximately 3.0%. Unless and until the Fed Funds rate is higher than real GDP, then it is questionable that the Fed’s interest rate policy is actually tightening.
Furthermore, many economists ignore the actual impact of M2 (money supply metric) relative to the broader measure of monetary base. The majority of quantitative easing did not impact M2 (broad measure of money and cash-like liquid assets) but rather materialized in bank reserves which is reflected in the monetary base. Therefore, while ample liquidity has been injected into the economy, the change in M2 has not been excessive, since much of it is held in bank reserves; hence the reversal of quantitative easing should not be overly restrictive on economic growth. It will primarily result in a decrease in bank reserves held at the Federal Reserve.
We believe it is premature to conclude that Team “Fed tightening”, both interest rate and monetary policy, will push the market to the economic cycle finish line.
Team “Corporate Earnings” is chalking up consecutive stage wins with each passing quarter. With the majority of 2Q corporate earnings reported, corporate earnings appear to be up another 21%. This team is drafting behind recent tax policy and corporate deregulation. Skeptics monitor the relationship between corporate earnings and GDP growth to identify expected downturns in corporate earnings. If earnings growth outpaces that of GDP (value of all final goods and services in the economy), many economists would expect corporate earnings growth to decline.
However, Brian Wesbury, Chief Economist at First Trust Advisors, points out that growth in GO (Gross Output – which accounts for business expenditures in addition to gross consumption) is a better point of comparison with corporate earnings. This relationship provides greater conviction that earnings growth remains sustainable.
Team Productivity continues to lead the Peleton. We noted in our last newsletter the growing concern about fiscal stimulus late in the economic cycle. Without further investment in capacity or sustained productivity gains, late cycle stimulus can lead to inflationary pressures which might convince the Fed to accelerate interest rate hikes. However, productivity, particularly in the “App Economy” (which now represents almost 2.2% of real GDP in the U.S.) and in Energy, continues to abound. In fact, by the fall of this year, the United States will become the world’s leading producer of crude oil, surpassing Russia and Saudi Arabia.
Therefore, it is perhaps a bit pre-mature to focus on capacity constraints and the tightening labor market as leaders to the finish line of the late cycle expansion. Team Productivity may continue to extend the race.
Economic Risks like the Alpe D’Huez Summit
And how does one assess the other risks to an extended economic cycle which crowd the macroeconomic horizon like fans lining the climb to the famous French alpine summit Alpe D’Huez?
Might the Fed move too quickly with its monetary and interest rate policies, thereby accelerating an end to the economic expansion? What happens if President Trump’s tariffs result in a full-blown trade war? Should investors take note of the bubble which is forming in multi-family housing or the recent softness in home sales? How might the market react if there is a change in control of the US House of Representatives and a shakeup of seats in the Senate in the fall? Volatility is braced to re-enter the market should any surprises manifest themselves. These are just a few of the risks to extending the late-cycle economy.
Our ViewIf one scans the data closely, we feel there is enough positive economic news to sustain economic growth into 2020. Risks to an extended growth runway are plentiful. Any surprises – economic, fiscal, or political – can easily translate into heightened market volatility. Currently, Team Yield Curve, Team Fed Tightening, Team Corporate Earnings, and Team Productivity are all getting attention in the later stages of the race. We believe a diversified multi-asset allocation with an appropriate level of volatility is best suited to navigate the remaining distance to the economic summit of the current equity bull market.
Enjoy the remainder of your summer.