Policy rate

The big news in the bond market over the course of recent weeks is that US Treasury yields have meaningfully declined, posting a recent intraday low of 2.16 per cent. This move defied consensus expectations but is consistent with the general soft patch in economic data that we’ve seen over the last month or so.

The latest payroll figure was soft relative to expectations. So, too, were first-quarter retail sales. And the upswing in inflation that dates back to July of last year has shown signs of stalling. In fact, when you add it all up we’re looking at a very soft quarter for the US economy. This has led investors to ask a couple of questions. First, they are starting to question the durability of the Federal Reserve’s current expansionary path. Second, they want to know whether this soft patch indicates the end of the current business cycle — one of the longest on record, incidentally.

Given the uncertainty around the president’s legislative agenda, the prospects of health care premiums continuing to rise, and growing concerns about the well-being of the automotive industry, perhaps it’s not surprising that some observers are wondering whether this marks the end of the cycle.

Signs of a schism?

There’s a schism opening up in the way economists view this. Some are in the late cycle camp, believing we are increasingly vulnerable to a downturn in economic activity. Others are firmly in the mid-cycle camp, pointing to the unique characteristics of the current recovery with the view that the expansion is on track to become the longest ever. To answer this question for ourselves, we look at a range of economic and financial indicators.

First, we look for emerging signs of excess in the real economy and/or excessive speculation in the market. When you look at real economic indicators, housing often provides early warning signs. Historically, it has often entered a downturn ahead of most other business areas. Yet today, affordability remains attractive on an historical basis, and although financing remains difficult, this has been the case for roughly the last 10 years, since the financial crisis. Importantly, financing rates are up only a half per cent from last year’s lows and even projecting further increases of a similar magnitude doesn’t change the affordability equation much. In addition, when you look at housing inventories, there’s no indication of oversupply.

The automotive industry has also been receiving a lot of attention. Here, there are signs of excess, with a growing volume of “sub-prime”-type auto loans being originated. As a result, lenders are already becoming more restrictive. However, although sales volumes are probably going down from here, there’s unlikely to be a precipitous decline and it is unlikely autos alone will sink the economy.

In energy, there were legitimate concerns about the industry in early 2016. In particular, there was a surfeit of new credit creation. But this has now washed through the system and we have survived the excesses in lending and the contraction in capital expenditure. The worst may now be behind us.

Turning to US retail sales, these are clearly soft, reflecting structural shifts in the market and different buying patterns. However, the fourth quarter was pretty strong and seasonal adjustment factors post the financial crisis have tended to bias the numbers lower in the first quarter.

Nothing in excess

In terms of financial indicators, high yield spreads have contracted meaningfully over the last year. However, default rates, which were at 4 per cent 12 months ago, are likely to be under 2 per cent this year. Consequently, if you look at default-adjusted spreads, they are about average. Also, there’s been no meaningful degradation in issuance quality. In addition, the proportion of issuance in triple-C bonds has gone down and there has been little covenant-light issuance. In short, we currently don’t see any evidence of excess in spreads.

Markets have been very optimistic regarding the prospects for constructive change in the US, but the reality is that until substantive changes are implemented, this optimism is largely based on expectations. Indeed, the new administration’s ambitious reform agenda is moving slower than expected and it’s likely that consumers won’t see substantive change in terms of increased spending power until at least mid-2018. Currently, there are tangible developments taking place on the regulatory front, but here too there are big lag effects in terms of translating this into improved economic activity. With respect to taxes, health care and infrastructure, the markets may be disappointed relative to early expectations but ultimately constructive change is likely in the cards, which could translate into improved growth prospects in 2018. In the meantime, the US economy continues to demonstrate many of the characteristics that have defined this unique post financial crisis business cycle.

More generally, the global growth backdrop is improving — both in developed and developing markets — and there’s been an upswing in export activity. In conclusion, we believe we are in the middle of the business cycle, and the US economy has a ways to run yet. As a consequence, the US central bank remains on course to consistently move toward a higher policy rate. In the words of the American rock band, Jack White’s Raconteurs: Steady, As She Goes