The Economic Cycle Still Exists

Predicting the outcome of the economy and markets (or any prediction for that matter) has and continues to be a fool’s errand. It is difficult enough to establish the current state of the current cycle, as evident by conflicting market signals through prices and valuations of financial assets, commodities and labor. Especially this cycle, which has seen unprecedented stimulus by both Fiscal and Monetary Policy, extending this economic expansion into the longest, yet most tepid in recorded history. Since the troughs of the Global Financial Crisis in 2008, it has been a cycle characterized by both fiscal and monetary easing, a Sovereign Debt binge, demographic turning points, political populism, supply chain disruptions, negative oil prices, the fruition of “helicopter money”, Europe’s industrial demise, trade wars, and stratospheric technological advancements, all emanated within the span of the last 15 years. I believe we are in the later stages of an extended (by QE and Fiscal stimulus) economic cycle and will address the signs making a case for turning points within the economy that can turn it into a painful recession.

Today, bulls will point to consumer spending, GDP growth and a strong labor market as signals of the US market’s health. The view can be further supported by the extended shortages of labor and housing units, as well as the relative historical strength of household balance sheets. Even corporate balance sheets, outside of commercial real estate, look to be solid. On the other hand, bears may highlight the trends of deteriorating credit quality (both commercial and household), and mean reverting labor supply dynamics as potential catalysts to throw the economy into an unexpected recession. Here, we will explore the key factors commonly observed to be bellwethers of market conditions, the trajectory of the economy, and the path for both Fiscal and Monetary Policy to finally provide actionable decision making around investment portfolio positioning.

Examining the broad macro set up would be a good starting point to assess the economy’s position regarding its long-term cycle. The table below summarizes features of stages of the economic cycle well enough.

GDP

In terms of US GDP growth, excluding the impacts of the brief COVID recession and recovery, the economy is growing around the same pre-COVID trend, despite substantially higher interest rates, an inflation shock, and growing prospects of geopolitical risks. Yet, strong consumer, and corporate balance sheets, coupled with record high fiscal spending (6% of GDP) for programs such as the Inflation Reduction Act (over $300 Billion allotted), and the Infrastructure Bill (over $448 Billion), have kept the economy in good shape despite the challenges it had been facing. Even now, the Atlanta Fed’s GDPNow, a current estimate of 1Q2024 GDP is estimated to be at 2.9%. Which is around its 1-year average, and above the 5-year average.

Labor and Wages

The labor market seems solid from a headline perspective with unemployment around 3.80%. Even around full employment, the US economy continues to add jobs, and unfilled positions still exceed unemployed persons (defined as working age and actively seeking employment). The gap between unfilled positions and those looking for a job has started to shrink precipitously, however. The initial widening of the gap should be attributed to COVID lockdown dislocations, and we can witness a normalization. We may see more people enter or re-enter the workforce, as they spend through their COVID savings, and student loan freezes had expired.

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Evidently, the pace of job additions has been shrinking on a weekly basis, falling towards the longer-term trend relative to GDP. The headline data also does not discriminate between the quality of jobs, with part-time labor rising compared to full-time employment. The share of part-time employment additions compared to full-time is worrisome at the least, and likely indicates that lower income families are taking on second or third jobs to adapt to the inflationary environment. Wages are believed to be cooling off too, after having risen around 5% on average throughout the post-COVID period. Could such a strong labor market sustain itself amidst the current level of interest rates?

Business and Consumer Sentiment

For that to materialize, business sentiment must shift dramatically, and we would need to see profit warnings across the board to get to that point. While corporate profits, and balance sheets don’t signal any stress, it is the weakest of the bunch that fall first through the cracks, ie Office and Retail Real Estate and Regional Banks showing different symptoms from the same virus. The consumer has also been a stalwart of the economy, as retail sales continue to beat expectations. Yet, at the margin, there are signs of an inflection point. ?Delinquencies on credit card debt and auto loans are on the rise. Of course, it is the most vulnerable demographics that get affected by inflation and higher interest rates in the initial stages of an economic slowdown. Such pressure on consumers may slow down demand, which may cause businesses to reduce their spending, including their wage structures.

So, we can see how the prevalence of higher interest rates are only just starting to impact business on the ground. Yet, the worst is yet to come. We are approaching a staggering wall of debt about to mature by the end of 2024 and through 2025, that will most likely have dire consequences on corporate profits, and investment plans.

Inflation and Interest Rates

Finally, inflation excluding food and fuel, continues to be sticky, with headline CPI seeming to settle around 3.5%. This impedes the Federal Reserve from finding room to cut rates to ease the financing burden of Corporates and the US Treasury (a large supplier of dollars given its fiscal deficits). Higher rates for longer will eventually erode Corporate Profits, and Consumer spending. A large degree of inflation has been driven by homeowner’s equivalent rent, which for Government CPI figures, are lagging the actual nature of rents. The Zillow Rent Index is believed to be a more current measure of rental growth. Thus, it would be safe to assume, with wage growth tapering off, that a resurgence of inflation outside of fuel and food prices would be a low probability.

Security Market Pricing as Contra Indicators of a Contraction

Piecing all these factors together, the state of the economy is arguably within the late stages of peaking to early stages of contraction. Even when macro indicators are cross referenced with market signals from key asset classes, we see typical late-stage economic expansion behavior. Commodities typically perform very well, along with other risk assets. Gold on the other hand, usually seen as a haven from market and geopolitical turbulence, had performed admirably. Long bonds are acting similarly, with Fed Funds Futures implying a 34% probability of two rate cuts by the end of the year, and 43% probability of no rate cuts. This development is quite interesting to watch unfold, as early in the year, the market was adamant that rate cuts would materialize by the early second quarter of 2024. Equities, meanwhile, are priced for perfection, trading at a Forward P/E ratio around 20X. This cross-asset price action is typical of a late-stage expansion, where in my estimation, the market views the economy expanding and overconfidence sets into its sustainability. Yet, I doubt that two rate cuts (should they materialize) would be enough to stave off more pain transpiring through the economy simply for the prevalence of such large sums of debt, and valuations on risky asset classes. I also doubt that the Federal Reserve will have much room to cut, as it battles to restore its credibility while fighting inflation. Inevitably, the Federal Reserve will keep interest rates too high for too long. Economists were likely only wrong in their 2023 recession predictions because they were too early. I might be guilty of making that same mistake at this time of writing as well. Next, this cycle’s case study of the Leading Economic Index will show how difficult it has been calling turning events within this abnormally long economic cycle.

The Leading Economic Index

The Leading Economic Index (LEI), long known for its statistical prowess in determining recessions has been signaling one since December, 2022, yet the economy grew 2.5% on average since then. While up until now, my discussion on the labor market, and consumer sentiment was helpful in establishing the current state of the economy, investors need to know where the economy will go next. The Conference Board which tracks the LEI has composited a total of 10 macro components that have been determined to be leading indicators of the economy’s path. Yet, despite its track record, the Conference Board has actually ditched its recession expectations, since the economy has been broadly outperforming economist expectations.

Recently the yield curve, consumer expectations and new orders indices have contributed to the lion’s share on the drag of the LEI. What has been the most positive indicator of the economy within the 10 indicators you might ask? The S&P 500’s return. Yet, the stock market’s strong performance could arguably be mostly attributed to interest rate cut expectations, and the contribution from a handful of stocks that have had an outsized effect on the Index. The LEI would have been flashing a more bearish signal had it not been for the stellar performance of the stock market.

I tend to believe that corporate profits will start to reflect the warning signs given by leading macro indicators, and thus stocks will have a rude awakening at some point within the next 18 months. I tend to refer to Benjamin Graham’s quote about the market when it doesn’t make sense to me, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Very hard to run against the market in the long run, but I do believe the market could be irrational in the short run, driven by emotional and cognitive biases that result in price dislocations. It is at these points in time where the bulk of returns and losses are made for most investors.

Within a late peak cycle stage or early bear market, it would be important to think about safety first. As long as money markets are providing a safe 4-5% return, it would be wise of any investor to take advantage of such feature which a whole generation of investors had only read about in textbooks. Secondly, precious metals have performed admirably in the past within late bull cycles and into a bear cycle as the realization that lower rates would be inevitable. Although energy performs really well into the late stage of an expansion, timing it would be a very challenging task. I would avoid the frothier parts of the stock market, most notably AI. Although the long-term benefit of AI has its own investment merits, most AI plays identified till date look too expensive given the assumed stage of the economic cycle. Finally, within Real Estate and Private Equity some deep value opportunities will start to appear as the stress of debt and peak valuations sets some good businesses up for sale at a discount. I’ve yet to see much indication, however, that valuations have come down materially within Real Estate and Private Equity on an aggregate level. Private markets usually lag public securities, and I expect the aggregate Real Estate and Private Equity to experience some turbulence. It is most important than ever, to stay diversified and disciplined, while keeping long term investment goals in mind as investors navigate through what I see as a turning point in markets and the economy.

None of this is investment advice. For information and entertainment purposes only. Always seek professional investment advice from an investment advisor before taking any financial decisions.

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Abdullah AlShalan, CFA