This inscrutable economic cycle

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Where are we in the economic cycle?

Economies move in a sloppy cyclical pattern. In a recession, consumers are watching their wallets and companies are keeping inventories and investment low. Asset valuations are depressed. Everyone feels poor today and expects to feel poorer tomorrow.

Then, for whatever reason, things feel a little less bleak. Families open their wallets a tiny bit. Companies realise inventories need restocking, plants need updating, and they need more staff. Investors realise assets are too cheap, and buy. Before long, production, investment and valuations are rising. Recovery!

Excesses start to creep in. Inventories are high. Capacity meets, then outruns demand. Asset prices get a bit peaky. Things still feel good, but the hour is growing late. Some small shock — perhaps provided by the central bank — is enough to make companies realise they need to cut prices and slow investment. Consumers become hesitant. Recession again.

This is all too schematic. There is no public service announcement on the day a recession turns into a recovery, or when the recovery ages in a ripe, then an overripe expansion. Least of all does anyone ring a bell when a recession begins; on that day, plenty of people think the boom is still going strong. The cycle is hard to read when you are living inside of it. It is even harder to read while supply and sectoral disruptions are rippling through the economy, since the archetypical cycle is about demand fluctuations.

Since the shocks of the pandemic, the cycle has been so inscrutable that some people think we are at the beginning of it while others think we are at the end. Here is Morgan’s Stanley’s Michael Wilson on Monday, in a note called “Late Cycle Playbook Is Back”:

We view this year as an extension of the late cycle period often experienced when the Fed is expected to pause or reverse its hawkish policy stance. As is typical in such periods, multiple expansion has moved ahead of where macro fundamentals dictate fair value to be, placing the burden on a growth reacceleration and/or incremental policy support that’s not already in the price in order to keep multiples elevated …

Late cycle/more conservative [market] factors are outperforming once again. Specifically, we note that high cash, low debt and low capex factors have performed well over the last month … despite the rate move higher since the local peak in equities in late July, growth has outpaced both value and cyclicals. Further, a broad set of early cycle winners have seen relative underperformance recently.

In general, in a recovery, stocks of companies that no one would touch in a recession do well: small businesses, cyclical industries, high idiosyncratic risks, carrying lots of debt. These are the companies that both benefit most from a better economy and will have been most oversold during the recession. As the cycle ages and approaches recession, you want the opposite: companies that can remain stable or even grow through economic headwinds. Staples and secular growth stories are standard recommendations, as are the largest companies. Wilson and his team throw in industrial stocks, the class of cyclical stocks that tend to perform best as the cycle ages, as well. 

Bank of America’s Savita Subramanian takes the other side of the argument. On Monday, she wrote that her team’s cycle or “regime” indicator has flipped from downturn to recovery, in a note called “Recovery Confirmed: Value>Growth, Risk>Quality, Small>Large”:

Admittedly, the last few years have not felt well-defined from a “cycle” perspective, with asynchronous upturns and downturns during and after COVID-19. But our US Regime Indicator has remained relevant in capturing factor trends — e.g., Jan to June’s Downturn saw mega caps, Growth and Quality outperform, true to form. The indicator improved for its 2nd consecutive month in August, officially entering a “Recovery” phase. Five inputs improved (Inflation, GDP forecast, 10-yr Treasury yield, ISM PMI, and Capacity Utilization), three weakened (EPS Revision Ratio, Leading Econ Indicators and High Yield spreads).

Here is the chart of the BofA regime indicator, which cooks together the data mentioned above using a Z-score. Notice the little button hook up at right (are there any similar looking head fakes in previous cycles?):

Subramanian says it’s time to buy value and risk. She particularly liked financials and high dividend payers.

How is it possible that two competent strategists, with the same data sets available to them, come to opposite conclusions about where we are in the cycle? Much of it seems to come down to methodology. Wilson focuses more on market indicators, such as which sectors are outperforming, whereas Subramanian leans more heavily on the macroeconomic data. We find elements of both compelling, but neither spend time on three factors we think are important: employment, housing and the pandemic’s wildly uneven effects on the goods and services sectors.

Starting with employment, it is odd to say we are early in the cycle with payrolls growth falling fast and unemployment, at 3.8 per cent, rising off its cyclical low of 3.4 per cent. Bottoming unemployment generally happens late into a cycle. This is because the labour market is a lagging indicator; workers are not often timing swings in the economy, unlike, say, manufacturers or homebuilders.

If the labour market looks firmly late cycle, the housing market is throwing up a big old shrug. Housing disproportionately matters to the cycle, because it is big, levered, swingy and widely owned (some say it is the business cycle). We wrote more about housing on Monday, but the rough picture seems to be: in contraction, but not as bad as before. On a sequential basis, private residential fixed investment fell 1.2 per cent in the second quarter. But the quarterly shrinkage was closer to 6 per cent last year. Housing starts have picked up this year as homebuilders rush into the breach.

Perhaps it is not surprising that the cycle feels scrambled after the pandemic’s huge sectoral shocks. The goods-to-services shift is well known, but less noticed is the fact that real spending is now shifting slowly back towards goods. The chart below shows the ratio of real personal consumption expenditure on goods versus services. The rotation towards spending has bottomed out:

The rise in goods spending has coincided with an uptick in manufacturing activity surveys, which fits an early cycle interpretation:

We wonder if aggregate indicators such as Subramanian’s, which largely capture fluctuations in demand, work well when coping with supply-driven sectoral shocks like what we have been experiencing. 

Wilson and Subramanian are trying to place the current moment in the standard cyclical economic framework. This is a worthwhile project. But it is hard not to suspect that the answer to “is this recession, recovery, mid-, or late-cycle?” might be “none of the above”. The pandemic may have knocked the different parts of the economy out of their usual orbits, and it may take a while longer before the standard patterns reassert themselves. (Armstrong & Wu)

One good read 

The liberal whisperer.