Further To Run In This Business Cycle by Marie M. Schofield, CFA, ColumbiaManagement
- While the U.S. business cycle is likely past its mid-point, its durability should not be measured by length alone.
- What was perceived a weakness earlier in the cycle is now a strength — the tepid nature of this recovery has prevented the buildup of excesses that normally precede recessions.
- It will be some time before any imbalances build up to the point of excess and stymie the expansion. In short, this expansion has much further to run.
Marie M. Schofield, CFA, Chief Economist and Senior Portfolio Manager | January 5, 2015
For our full 2015 outlook, please read our 2015 Annual Perspectives.
The U.S. economy reached a milestone of sorts recently; the current business cycle has now surpassed the last one in length (measured peak to peak). The prior business cycle started in 2001 and continued until the December 2007 peak, lasting about 6.8 years. The cycle actually exceeded the post-war average of about 5.6 years but was shorter than the nine-to-10-year business cycles of the 1980s and 1990s (Exhibit 1). 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 has the final say on dating business cycles, but it does so using a variety of measures and only with hindsight. For instance, the group announced in December 2008 that the last recession began in December 2007. Should we be concerned about the current business cycle based on length alone? The short answer is no, and it generally appears this cycle has much further to run.
The argument that the current business cycle is far from over is illustrated by the Columbia Management “investment clock.” Our Global Asset Allocation team uses the clock to monitor the business cycle, its various phases (recovery, expansion, slowdown and contraction) and its current position. The clock uses eight economic data series that are highly correlated to the business cycle and aggregates these into a composite indicator, which is depicted in the “swirlogram” in Exhibit 2. The cycle remains in the expansion phase, although we note that the positioning within the 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.
Typical causes of business cycle peaks are not evident today
Business cycle peaks always have causes. These are the typical causes:
- Unexpected systemic events. These present risks that are unpredictable but unquestionably negative and can short-circuit expansions. This category is broad but includes bank failures and price shocks.
- Economic or financial imbalances. Unsustainable conditions ultimately require adjustment. Inventory swings and excesses can affect growth in the short term (such as early 2014 when an inventory contraction contributed to a negative gross domestic product reading) but have rarely caused recessions, at least in the last few decades. To derail an expansion, excesses need to be large and the associated adjustments need to impact a broad swath of the domestic 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.
- An extended period of Federal Reserve (Fed) tightening. Usually in response to an overheating economy and inflation, these periods are marked by ongoing rate hikes by the Fed, causing the yield curve to invert — that is, short-term rates become higher than long-term rates. This, in turn, heralds an environment where lending is too tight given shifting economic fundamentals and growth trends. Yield curve inversions are an important recessionary indicator and have been evident prior to nearly all economic contractions in the post-war period.
A review of these factors reveals few if any factors that would signal risk to the current business cycle. In the current cycle, 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 where the Fed is adhering to a zero interest-rate policy.
In addition, there are few if any economic or financial imbalances at present. Indeed, a hallmark of the recovery to date may be an inherent lack of imbalances due to its muted nature. While we expected fragile growth would make the economy more vulnerable to shocks and recession early in the cycle, it should now be seen as 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 are worrisome when leverage (debt) is high and financial conditions (like lending) are tight. But new regulatory constraints and macroprudential policy initiatives (designed to reduce the severity and frequency of asset bubbles and excessive credit growth) have prevented a buildup of financial leverage and credit, and financial conditions continue to ease. While financial conditions may begin to tighten this year, it will be some time before they are considered tight.
Finally, while systemic risks are inherently unpredictable, these are present primarily in the global environment. Systemic risks 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 United States may prove more resilient.
We emphasize that 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 buildup 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. In short, this expansion has much further to run.