Business Cycle Past Mid-Point: Room to Run

The U.S. economy passed a milestone of sorts in August, in that the current business cycle has now surpassed the last one in length. The prior business cycle started in 2001 and continued until the December 2007 peak, lasting 6.8 years. This is longer than the post-war average of 5.6 years, but shorter than the business cycles in the 1980s and 1990s which lasted 9 to 10 years. The question about the current business cycle’s longevity is relevant, considering peaks mark the start of recessions and turning points carry important implications for asset class performance. The National Bureau of Economic Research (NBER) has the final say on dating business cycles, but does so using a variety of measures and only with hindsight. For instance, the group announced in December 2008 that the last recession began on December 2007—a full year after the recession was already in full swing. Should we be concerned about the current business cycle at this point based on length alone? The short answer is no, and it generally appears this cycle has more room to run.

Exhibit 1

One factor arguing for this is Columbia Management’s Investment Clock which is used by the Global Asset Allocation team to monitor the business cycle, its various phases and its current position. The clock uses 8 economic data series which are highly correlated to the business cycle and aggregates these into a composite indicator which is depicted in the “swirlogram” in the chart below. It remains in the expansion phase, although we do note that the positioning within expansion has been quite shallow after exiting a mid-cycle slowdown last year. This is consistent with the recovery experienced to date, which can be characterized as modest but stable nonetheless.

Exhibit 2

Source: Columbia Management Investment Advisers, LLC

Business cycle peaks always have causes, and these typically fall into certain categories. First, systemic events present risks that are unpredictable but unquestionably negative and can short-circuit expansions. These include bank failures or price shocks, although this category is quite broad. The second category refers to some economic or financial imbalance that is unsustainable and requires adjustment. Inventory swings can impact growth in the short term (such as earlier this year when an inventory contraction was the contributing factor to the negative GDP reading), but these have rarely caused recessions at least in the last few decades. Excesses need to be large and the associated adjustments need to impact a broad swath of the economy. We can point to the lethal combination of housing, credit and leverage in the last recession. Excessive investment was a contributing factor in the 2001 recession. The third category follows an extended period of Fed tightening in response to an overheating economy and inflation. Those periods are marked by ongoing Fed rate hikes causing the yield curve to invert and heralding a policy environment that may then be too tight given shifting economic fundamentals and growth trends. As a result, yield curve inversions are an important flag as a recessionary indicator and have been in evidence prior to economic contractions in the post war period.

A review of these factors reveals few if any candidates that would signal business cycle risks. Growth and inflation remain below the Fed’s forecasts and output gaps remain modestly negative. The Fed has yet to even begin tightening policy and it would be mathematically impossible to construct an inverted yield curve in the present environment of ZIRP. There are few if any economic or financial imbalances at present due to the muted nature of this recovery. While we expected that fragile growth would make the economy more vulnerable to shocks and recession early in the cycle, it should now also be seen as a strength in the second half of the business cycle—weak growth has not allowed economic excesses to build up. Capital investment remains low and housing investment is still recovering from the last bust. As to financial imbalances, some may point to compressed risk premiums and excessive risk-taking. Those risks are worrisome when leverage is high and financials conditions tight. But new regulatory constraints and macro-prudential policy initiatives have also prevented a build-up of financial leverage, and financial conditions continue to ease. While financial conditions may begin to tighten next year, it will be some time before they are considered tight, although the unwind of unconventional Fed policy may itself present risks. Finally, while systemic risks are inherently unpredictable, these present primarily in the global environment. They will, however, have an undeniable effect on both global and domestic growth, particularly for more open economies exposed to trade while closed economies like the U.S. may prove more resilient.

So while the U.S. business cycle is likely past its mid-point, its durability should not be measured by length alone. It is somewhat ironic that what was perceived a weakness earlier in the cycle is now a strength—the tepid nature of this recovery has prevented the build-up of excesses that normally precede recessions. And it will be some time before any imbalances build up to the point of excess and stymie the expansion. So in our view this expansion has much more room to run.