A long cy­cle

If one can form a view on the next re­ces­sion and its tim­ing one can po­si­tion the port­fo­lio ac­cord­ingly

Business Standard - - OPINION - AKASH PRAKASH

We are now ap­proach­ing nine years for the cur­rent busi­ness ex­pan­sion in the US. We are al­ready tied for this be­ing the sec­ond­longest ex­pan­sion on record, and it seems to have the legs to con­tinue for a while longer. The cur­rent cy­cle reached a trough in June 2009, and will have com­pleted 106 con­sec­u­tive months of eco­nomic ex­pan­sion by the end of April

2018. This will make it tied for sec­ond place with the busi­ness ex­pan­sion be­tween Fe­bru­ary 1961 and De­cem­ber 1969. In May, this cy­cle will move into sec­ond place for the du­ra­tion of ex­pan­sion, with only the 10-year busi­ness ex­pan­sion be­tween March 1991 and March 2001 be­ing ahead.

This is im­por­tant be­cause ob­vi­ously, the cy­cle is ma­tur­ing.

We can­not have a con­tin­u­ous ex­pan­sion. We will have a re­ces­sion at some stage again. A re­ces­sion im­plies steep falls in cor­po­rate earn­ings, neg­a­tive GDP growth and a bear mar­ket in stocks. Mar­kets nor­mally top out six months prior to a re­ces­sion be­gin­ning. Thus, given the length of the cur­rent eco­nomic ex­pan­sion in the US, how much longer can it sus­tain and when do we tip over into a re­ces­sion are im­por­tant de­ci­sion points to form a view on the mar­kets.

First some his­tory. As per Deutsche Bank (DB), look­ing at data all the way back to 1854, the av­er­age length of an eco­nomic ex­pan­sion in the US has been 41 months. The me­dian length has been 32 months. How­ever, since 1961, the av­er­age length has in­creased to 75 months. From 1981 on­wards the av­er­age length of these ex­pan­sions has in­creased fur­ther to 98 months.

Var­i­ous com­men­ta­tors have pro­vided ex­pla­na­tions for this in­creased sta­bil­ity in eco­nomic per­for­mance and elon­gated busi­ness cy­cles.

One ex­pla­na­tion is bet­ter eco­nomic man­age­ment on the part of the Fed­eral Re­serve. It has been ahead of the curve and al­lowed the eco­nomic cy­cle to play out fully, rather than short-cir­cuit­ing the ex­pan­sion. Se­condly, we have seen a sus­tained and struc­tural de­cline in in­fla­tion. This de­cline has been en­abled by greater slack in the labour force, as China en­tered the global sup­ply chain, and we had healthy labour force de­mo­graph­ics in the West. This slack, al­lowed the econ­omy in the US to run faster and for longer than usual with no wage pres­sures. Lim­ited wage pres­sures meant lim­ited in­fla­tion. With in­fla­tion trending down con­tin­u­ously, the Fed­eral Re­serve was able to be very mea­sured on in­ter­est rate hikes and al­low the econ­omy to ex­pand un­hin­dered.

Over this pe­riod of ex­tended ex­pan­sions, since the early 1980’s, we have also seen a sec­u­lar rise in debt, at the house­hold, cor­po­rate and gov­ern­ment level. This con­tin­ued rise in debt has also en­sured that eco­nomic ac­tiv­ity was both higher and less volatile than pre­vi­ous pe­ri­ods. In­creased debt al­lowed con­sump­tion to ex­ceed in­come growth.

DB makes the point that both these po­ten­tial causes of an ex­tended ex­pan­sion are now rev­ers­ing. In­fla­tion has prob­a­bly reached a trough, along with in­ter­est rates, and it is un­likely to go any lower. Sim­i­larly with debt; it seems un­likely that we can, from these el­e­vated debt lev­els, have a con­tin­ued sec­u­lar rise. If this is a cor­rect in­ter­pre­ta­tion of cause and ef­fect then we may have seen pos­si­bly the last busi­ness cy­cle of this length? Could this be the last cy­cle of over 100 months? Ob­vi­ously, only time will tell, but it is worth think­ing about. In­vestors have got used to long and profitable busi­ness ex­pan­sions. Their in­vest­ment ap­proach may have to change if we go back to shorter cy­cles and more eco­nomic volatil­ity.

The DB pa­per also takes a stab at try­ing to fig­ure out the tim­ing of the next re­ces­sion. As pointed out, this is an im­por­tant is­sue, as a re­ces­sion will in­evitably cause a bear mar­ket in stocks. If one can form a view on the next re­ces­sion and its tim­ing one can po­si­tion the port­fo­lio ac­cord­ingly.

They take three dif­fer­ent ap­proaches. Firstly, look­ing at the num­ber of months af­ter the un­em­ploy­ment rate in the US goes be­low the NAIRU (or the non-ac­cel­er­at­ing in­fla­tion rate of un­em­ploy­ment). On this met­ric, it takes about 36 months from when the un­em­ploy­ment rate goes be­low NAIRU for a re­ces­sion to hit. Us­ing this time­frame, we can ex­pect a US re­ces­sion to ar­rive by Septem­ber 2019.

An­other ap­proach is to study Fed­eral Re­serve in­ter­est rate cy­cles. We are now in the mid­dle of a sus­tained hik­ing cy­cle, hav­ing be­gun in De­cem­ber 2016. Go­ing by past his­tory, from the be­gin­ning of a hik­ing cy­cle, a re­ces­sion ar­rives in 41 months (me­dian — 33 months). By this timetable, we should see the next re­ces­sion in the US be­tween Septem­ber 2019 and May 2020.

The third ap­proach is to use an in­verted yield curve as the trig­ger. When­ever the yield curve be­tween the two year and 10 year in­verts, it is seen as a very re­li­able in­di­ca­tor of an im­mi­nent re­ces­sion. On av­er­age it takes about 15 months post in­ver­sion for a re­ces­sion to set in. While the yield curve is yet to in­vert, we are only about 50 ba­sis points away. If the Fed were to hike as we ex­pect, this gap should be closed rel­a­tively quickly. Given only a 15month lag, this in­di­ca­tor may also in­di­cate a re­ces­sion some­time in 2019.

Ob­vi­ously, no one knows what will hap­pen. It is still pos­si­ble that in­fla­tion re­mains very be­nign, and this busi­ness ex­pan­sion con­tin­ues un­abated. The cur­rent Goldilocks sce­nario may per­sist. Strong growth and good prof­its but no pick-up in in­fla­tion. How­ever, at some point this cy­cle has to come to an end. If we are ex­pect­ing a re­ces­sion to hit the US some­time in the mid­dle of 2019 (as per the DB anal­y­sis), then we should start wor­ry­ing about the mar­kets by the end of this year it­self. Also the last stage of a bull mar­ket, (if the above time frame is right) is no­to­ri­ously dif­fi­cult to in­vest in. We may have a last surge in the mar­kets which will leave any­one tak­ing risk off the ta­ble feel­ing stupid.

A chal­leng­ing time. How­ever, re­al­is­ing that we are near the end of the cy­cle and pre­par­ing for it is crit­i­cal. At some stage in the next nine months, you will have to take risk off the ta­ble, at least for US eq­ui­ties. Whether In­dia or any of the Emerg­ing Mar­kets can do well de­spite a bear mar­ket in US eq­ui­ties is a moot point. Some­thing worth think­ing about and com­ment­ing on in a sub­se­quent ar­ti­cle.

The writer is with Amansa Cap­i­tal


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