Why 'late cycle' thinking is wrong (and why that's good for stocks)
As you probably read or heard this week, 10% of economists surveyed by the National Association for Business Economics think the U.S. will enter recession this year and more than half expect one by the end of 2020. While NABE respondents didn’t say why, it’s likely because many felt it’s getting “late.’’ A post-war U.S. has experienced a recession every 5.5 years or so, making this 9.5-year expansion long in the tooth. It’s already the second-longest and almost certainly will become the longest this summer.
The thing is, there is no magical time limit to an economic cycle and particularly to this one, which has been behaving unconventionally in a number of ways. For example, even though unemployment has been at or below 4% for almost a year, wage growth and inflation have remain muted, contrary to what typically happens late in a cycle. Similarly, the Federal Reserve says it’s on pause, that its benchmark rates are close to as high as they’ll go and that it even may allow inflation to run above 2% to ward off worrisome deflationary expectations, all moves atypical for “late cycle.’’
What makes this cycle so different? For one, there’s still a lot of labor market slack. The labor-force participation rate (the share of working-age people in the labor force) never fully recovered from the financial crisis—it hit a 41-year low of 62.4% in 2015 and hasn’t move up all that much since, meaning that even though the jobless rate may be low, it’s not fully representative of the potential—and potentially much larger—labor force. In a similar vein, the broader U-6 employment rate that includes discouraged workers who’ve dropped out of the workforce also remains elevated. Add all these potential entrants in the labor force, and the jobless rate would be significantly higher.
Raises still hard to come by
Moreover, technology is changing the demand for labor. Companies increasingly are turning to software and robots, sometimes because they can’t find workers with the requisite skills, other times because cost-effective machines that don’t require pay and benefits and can work 24/7 can help them better compete in a global marketplace where consumers and users shop the world for the best deals. This means workers who push for a raise may get a pink slip instead, replaced by automation and artificial intelligence—an accelerating trend that has helped cause labor’s share of domestic income to continue to decline since the 1970s even as businesses’ share has been rising.
So how are investors supposed to know when it’s “late cycle?” Federated’s equity team considers six sets of data to be the most reliable leading indicators of recession: jobless claims, core PCE inflation, housing starts, yield curve, credit spreads and ISM manufacturing. While there has been some deterioration in starts and sharp narrowing in the yield curve as measured by the gap between 2-year and 10-year Treasuries, none of these indicators are anywhere close to recessionary levels. When they are, that’s when we’ll know we’re “late cycle.’’ Until then, we remain bullish on stocks and expect new highs ahead as history suggests bull markets tend to end in recessions, not before them.