Market Memo: Summer storms won't derail the long cycle

08-11-2017

Our earlier warning about a summer storm may well come to pass. While a near-term pullback is likely, we expect any correction to be relatively short and shallow—and a natural progression after a sharp market run-up and the lack of progress in Washington. But a material threat to this great secular bull market?  Unlikely, and here’s why:

  • Despite accepted wisdom, there is nothing pre-determined about the length of an economic cycle And references to their average length are simply not helpful. There have been only 10 cycles since 1950, too few from which to draw any “average” conclusions.  Although the present expansion is 32 quarters long, and the third longest since 1950, its age alone does not mean it is at risk of ending soon.  Each so-called cycle is unique, and the present one is probably the most unique of the bunch.
  • The Federal Reserve’s starting point is unusually below “neutral” Most cycles end when the Fed raises interest rates dramatically above the economy’s neutral point, sparking a pullback in short-term borrowing and long-term investment. The present cycle is unusual in that the Fed started hiking rates from zero and will soon begin—very, very slowly—to shrink its balance sheet from $4.5 trillion to an undefined neutral point, which some on the Fed think is $2.5 trillion. Note that prior to the 2008-09 crisis, the Fed’s balance sheet was normally in the $1.0 trillion range—far below present levels.
  • The service economy is inherently more stable Over the past 50 years, the U.S. economy has gradually transitioned from being industrial- to service-driven.  Service industries carry less working capital/inventories making them less prone to the dramatic production cuts and layoffs that happen in the manufacturing sector when interest rates rise and demand falls modestly. The growing mix of service sectors within the U.S. inherently makes it more of a stable “not-too-hot, not-too-cold” economy.
  • Structural forces are keeping wage inflation lower for longer A number of structural forces at work in today’s economy are considerably more powerful than in previous cycles. Many of these are keeping in check the natural inflationary pressures embodied in “The Phillips Curve”—that is, the inverse relationship between unemployment levels and the rate of inflation.

    For example, while unemployment is low, workers seeking raises are faced with competition from a variety of sources that were much less of a factor in previous expansions:  a large, globally available workforce ready and able to take their jobs away; the impact of automation (robots are becoming the marginal workers); the record number of people who have left the workforce—and for more money—who could be lured back; and the disruptive technologies that are putting entire sectors (think Amazon and retail or Uber and limos/taxis) under enormous deflationary pressures that don’t allow for robust wage hikes. Powerful demographics are also affecting average wage gains, especially the baby-boomer retirement wave that is pulling many high-wage earners out of the marketplace and replacing them with lower-earning millennials.
  • Technology is even transforming the supply curve for commodity production, keeping prices lower and less responsive to demand pickups One reason commodities are viewed as a traditional inflation hedge is that, in the short term, it is typically very difficult to expand production in the face of even a small demand pickup; the natural forces of supply and demand then push up prices. Increasingly, new drilling and mining technologies are changing this demand responsiveness. The oil patch may be the best example. The shale revolution is riding a sharply declining cost curve as it has shifted the marginal market from one dominated by large, long-term and slow-moving projects (think “North Sea”) to one dominated by many small producers capable of bringing on new production in months, not years, and at ever-lower lifting costs.  All this makes the natural inflationary forces coming from commodity prices less powerful.
  • Productivity and labor force growth are being underestimated Bears’ fears of a near-term end to this cycle are partly rooted in extensive literature on declining productivity and low labor-force growth, which combine for low potential GDP growth.  Some of this thinking is probably wrong-footed. For instance, muted labor-force growth measures are surely not picking up the growing labor force of robots, which as noted earlier, is keeping wages in check.  And the entire structure of GDP accounting was created to measure output in a widgets world, where the vast majority of output was easily measured, either in the form of bales of wheat or cars rolling off assembly lines.  But in today’s wired world, how are all the services we consume being included in the GDP denominator?  A Lyft ride to the airport, replacing a more expensive taxi ride, is the same service, but at a sharply reduced cost.  On a smart phone today, I can review the news and analysis of it in gaps of time that were previously dead zones on my schedule. How is that increased productivity measured?
  • The deep and terrifying 2007-09 recession changed the forward psychology of all the key economic players We’ve made this point throughout this secular bull.  An economy is nothing more than millions of individuals collectively making decisions that affect economic growth and inflation. With all of them deeply scarred from their experiences in 2007-09, the overheating of animal spirits that would normally spell the beginning of the end of the current expansion may be long in coming. Corporations become risk averse, reluctant to take on new investments.  Workers become more focused on job security than on squeezing their employers for every last wage gain. Monetary authorities become more dovish, concerned about hitting the brakes too soon and sending the economy back into oblivion. Politicians crack down on growth through excessive regulations, more focused on taming abuses that led to the last hyper cycle than in encouraging businesses to invest for the future. And investors hunker down in safer assets, less willing to push the prices of risk assets to the extreme levels needed to fuel a cycle-ending bubble burst.

    Ten years later, we are just now beginning to reverse this process under President Trump, something we call the “Wall of Hope.”  But we have a long, long way to go.
     

These are some of the key drivers of the Long Cycle, and for these reasons we see the present expansion continuing for several years, not months. Within this context, our 2019 target of 3000 on the S&P 500 seems quite achievable.