While difficult to recognize the signals in real time, most economic cycles follow a recognizable pattern apparent in hindsight. The bottom of every economic cycle is the point of maximum pessimism while the pinnacle corresponds with peak euphoria. Typically, at the bottom of a cycle stock prices reflect lower valuations and at the peak of the cycle extreme valuations. Similarly, interest rates rise into the top of a cycle and tend to be lower at the economic trough.
The term structure of interest rates is often a pretty good tell of the current state of a cycle. Central bank policy, with appropriate lags, impacts short term interest rates. The yield curve tends to flatten or invert into an economic slowdown and steepen into a recovery. The current shape and trend of the yield curve indicate we are late in the cycle.
Fiscal policy can also be a clue, although the lags are greater as markets react more quickly than policymakers historically. Moreover, policy response is not symmetrical; it’s easier for politicians to promote economic growth and spending than to rein in inflation and deficits. Current US attempts at fiscal stimulus and tax reform look mistimed. In a rush to get something done, for the sake of political expediency rather than economic necessity, mistakes could shorten the current economic cycle rather than extend it.
Existing economic conditions appear on a more normal course than one might assume given the severe correction to global growth in 2008-09. This cycle continues to extend and is likely to be one of the longest expansions in history. Indicative of its staying power is the fact that typical imbalances in capital and labor which customarily arise in late cycle environments have yet to develop. Perhaps, the subpar nature of this recovery is less likely to generate inflation or promote shortages. There is also plenty of evidence that secular forces such as technology, demographics and debt are significant headwinds to expanding and extending growth.
In the meantime, central banks have begun to coordinate a gradual tightening cycle through a combination of increased interest rate policy and a reduction in their balance sheets. They are all headed in the same direction even if traveling at different speeds. The excessive liquidity and easy credit conditions of the last eight years are slowly coming to a halt.
History suggests that it’s a mistake to ignore the warnings of central banks. It may not be the end, but often it has been associated with the beginning of the end. Nevertheless, to date, the impact of these actions on the market has been hardly discernable. Some observer might claim, in adding mileage to a well-worn idiom, we are entering an era of a new normal. Assuredly count me out of the “this time is different” crowd. Investors appear lulled into indifference even though this cycle has likely passed its apex.
As so often the case, this sort of human behavior is nothing new. Psychologists call this sensory adaptation. The exposure of our sensory receptors (sight, sound, smell, and touch) to the same stimuli over time neutralizes or dulls their sensitivity. As the name suggests, we adapt as our brain seeks out a new baseline. In essence, we create a new normal for our environment.
You might also be aware of this phenomenon from the “boiling frog” parable. According to the story, if you put a frog in a boiling pot of water, it will immediately jump out in reaction to the water’s temperature. However, that same frog, if placed in a pot of lukewarm water that is slowly heated, will remain in the pot until boiled to death. The story forewarns of one’s fate if failing to heed warning of danger until it’s too late. Like the frog, the question for investors is whether signs of danger are being ignored.
Market interest rates have risen marginally despite rampant speculation of an imminent collapse in bond prices. This has been an unequivocally positive development in prolonging the cycle. It’s also a sign of the debt burden that overhangs the system. We believe the late cycle rise in interest rates is underway and is likely to be muted relative to history. Short term interest rates are unlikely to exceed 2.75%. As a result, the 10-year Treasury is limited to a rise of approximately 50 basis points. Meanwhile, the 30-year Treasury may be anchored at current levels. No wonder there is so little volatility in bond prices.
Equity prices have been surprisingly strong for the last several years given the lackluster top line revenue growth and high valuations. Lower interest rates play an important role in the rationalization of higher equity valuations. It’s also true however, that companies have become quite adept at managing their balance sheets and more cost-effective managing the operations of their businesses. In the era of stock buybacks, mergers and acquisition activity and private equity there simply is less public market equity available at a time when the individual investor is starting to re-embrace equity markets. The technical flow factors remain strong. Active management strategies are consistently losing out to low-cost index products. That trend should continue. The market will eventually succumb to liquidity shocks or higher levels of volatility in which the ETF models will be tested.
Next year will be tougher for equity markets in terms of earnings comparisons and rising trend in interest rates. However, confidence is strong and will continue right up to the next recession. Equity markets tend to be the last market to discount risk. The risks should be evident in credit, interest rate and currency markets long before they are reflected fully in equity prices.
The probable destination of this economic cycle is another recession. Historically, the backdrop for an economic contraction is tightening financial conditions, inflation and rising interest rates. We are beginning to see some of the signals that provide an early warning: High debt levels globally will limit growth rates between now and then, and Central banks will marginally normalize markets and be restrained in their ability to respond to slack demand. Additionally, despite low volatility indicators, geopolitical risks are rising and could trigger an earlier contraction.
However, like the story of the boiling frog, and as is typically the case with economic cycles, we will likely fail to identify the trouble we are in until it’s too late to respond. That’s the unfortuante true normal.
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