US entering late cycle, but no immediate threat of recession

January 03, 2019 11:18
Unemployment is now at multi-decade lows in developed-market economies. Photo: Bloomberg

Having begun on a wave of optimism over the prospects for another year of synchronized global growth, 2018 instead developed into a year of divergent trends and de-synchronized growth.

Increased geopolitical and economic uncertainties like US-China trade frictions, Iran oil sanctions, crises in several emerging market economies, and much else besides came to weigh ever more heavily on financial markets.

The current majority consensus is that we are in the mature (or late) stage of this business cycle. A record 85 percent of fund managers say the global economy is in the late cycle, 11 percent above the previous all-time high in December 2007. Yet most recession gauges are not even flashing amber. 

Despite the current media preoccupation with recession, we still think it is too early to worry about the end of this cycle. The term “late cycle” really should describe a particular state or condition of the economy, not to a period of calendar time.

It can easily last for a number of years, and in the past has delivered lower but still positive real returns to investors. It has taken the United States 10 years to catch up with the losses from the global financial crisis. Thus, we view the US as only just entering the “late-cycle” phase, which by itself poses no immediate threat to investors.

Of the seven recession signals that we follow in our US Recession Dashboard, three are neutral and four are green. According to a study by the US economics team at Bank of America Merrill Lynch, five monthly economic indicators that have been closely linked with US recessions (initial claims, auto sales, industrial production, Philadelphia Fed survey, and aggregate hours worked) suggest that no thresholds were about to be breached.

Normally, the late-cycle inflation is cost-push, rather than demand-pull. The giveaway is that profit margins almost always shrink late in an expansion. While history reveals it is possible to experience an “earnings recession” without an economic recession, there has never been an economic recession when earnings were still growing strongly. In the late cycle, labor is almost always the major source of cost pressure.

So the question of recession timing brings us back to the perennial debate: When will labor market tightness lead to a material acceleration in labor costs?

That leads to questions about the NAIRU (non-accelerating inflation rate of unemployment) – a theoretical construct that has eluded measurement in practice and therefore has been of little value to policymakers.

Unemployment is now at multi-decade lows in developed-market economies, and below most economists’ estimates of NAIRU. Estimates of the natural unemployment rate were clearly much too high in the mid-stages of this business cycle and have been repeatedly revised lower ever since.

Will this process reverse in 2019? That is probably still the most difficult question facing investors over a horizon of 12 months or greater.

Some investors are worried that the recent plunge in the crude oil price implies a sharp slowdown in the world economy is underway. But should investors really be worrying about oil just now?

Oil prices as a guide to global demand have occasionally sent investors some very misleading signals. For example, in the mid-2000s the world crude price weakened and global growth remained resilient, then the oil price surged in 2008 just before the onset of the global financial crisis.

Later, during the post-crisis recovery, oil prices tumbled in 2014, but global growth only decelerated a little. 

We think the reason for these misleading signals from oil prices is rather obvious; there have been frequent shocks to both global oil supply as well as demand. That is not the case today.

The recent sharp 20 percent decline in November reflects an unanticipated glut in supply, not a collapse in demand, so cheaper oil is thus a tailwind that should help to support growth. It raises household disposable income and hence consumption in oil-consuming economies.

We think only if oil price falls and remains below US$50 per barrel is there likely to be a significant negative impact on US shale oil investment and a headwind to global growth. In fact, over a six-to-12-month horizon we are bullish on crude oil as we expect the Organization of the Petroleum Exporting Countries to curtail output and the recent inventory rebuild to run off quite quickly.

Every bear market starts off with a dip, but not every dip goes on to trigger a bear market. So how can investors distinguish between the two cases? Should the fourth-quarter 2018 correction be sold on further dips, or bought aggressively? 

Of these two choices, our strong preference is for the latter. While 2018 was the year when politics dominated stock markets, 2019 could be the year that brings renewed focus on the economy. Some geopolitical concerns have been mulled over for so long that they have lost the power to shock. And the global economy faces a moderation in growth at the margin, not a meltdown that the media talks so much about.

We are struck by how many of the sell-side 2019 outlooks that have landed on our desk are at best cautious or negative in tone. Is it time to take the other side of the trade?

Looking to Main Street rather than Wall Street, guidance from management on earnings remains positive while forward multiples are back close to their historic averages. For example, the MSCI AC World forward price-to-earnings ratio has de-rated to a below average 13.6 times.

Stocks appear inexpensive relative to growth, cash flow, and bonds.

Meanwhile, positioning is light and sentiment depressed. Moreover, in those few cases historically where a strong global economy was accompanied by flat or negative stock-market returns, the following year has always seen a strong rebound.

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Senior Strategist (Asia), Capital Markets & Strategy Team, Manulife Asset Management