Equities typically fall into a bear market around recessions, with
the S&P 500 down a median -21%. So 9+ years into the current recovery, market attention is keenly focused
on how late the cycle is. Are margins and earnings peaking? Is the flattening 2s10s yield curve pointing
to an imminent recession?
- What do fundamental metrics indicate as to how
advanced the cycle is? The long duration and measures of slack in the labor and output markets
unambiguously suggest the cycle is very late. By contrast almost all other indicators, ranging from
inflation or cost pressures generated by that limited slack, the cyclical components of demand (housing;
durables; and investment spending), confidence, corporate and household leverage, delinquencies and
default rates, bank lending standards, margins and earnings, all suggest mid- or in some cases even
- The “late” cycle phase when slack is limited can go on for quite
long. Limited slack by itself does not end the cycle. What does is either cost pressures that it
generates or stretched spending, leverage, overconfidence or other excesses that it has historically
coincided with. None of these currently appear to be in place. In the last 3 cycles, the late cycle phase
lasted 2-4 years which in the current context would put the next recession potentially as far out as
2021. With core inflation having fallen short of the Fed’s target for 10 years, we expect it to continue
to emphasize symmetry around its target and welcome not fret moves above 2%, sticking to its current
guidance, possibly moving it up modestly. Moves up in the labor force participation rate, an increase in
productivity growth and a higher dollar, all of which are elements of our baseline view, would act to
lengthen the cycle.
- Getting out early can be costly. Average market returns
during the late-cycle phase have not been particularly different from the mid-cycle phase. So historical
ex-recession annual price returns of 12% are a reasonable indicator of potential returns in this phase.
The timing of the move from late to end cycle is always unclear in real time and if the cycle goes on for
longer would imply significant foregone returns amounting for example to median cumulative 42% during the
late cycle phase of the last 3 cycles.
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