Economies tend to fluctuate in a cyclical pattern with periods of expansion and contraction. So you might think it would be easy to figure out where we are in the cycle and when things really change. But sometimes the economy sends conflicting signals. Fortunately, Morgan Stanley has a business cycle model for this. Unfortunately, however, the economy is sending a clear message that it has just entered a 'recession' phase…
Wait, how do we know that?
Morgan Stanley's model doesn't just track hard economic data like employment and manufacturing production. It also incorporates soft data such as consumer confidence, market data such as yield curves, credit data such as loans, and even corporate invasion data such as mergers and acquisitions (M&A) and corporate bond issuance.
The model analyzes all the data, paying attention to how various economic indicators change. change Not just high or low, but over time. And by combining data, we track how many different indicators are moving in the same direction and for how long.
For a cycle to reach a tipping point, more than 60% of the model's indicators must be stronger or weaker for three consecutive months compared to their levels six months ago. This introduces a slight delay in signal transmission, but improves reliability as the cycle indicator does not constantly jump between phases.
This method has many advantages. Proven both theoretically and empirically, rule-based (and therefore less susceptible to bias), and comprehensive, he boils down the economy into one easy-to-understand indicator. This makes it a great tool for seeing the big picture and separating signal from noise.
So what do we say now?
Well, after showing “expansion” for 19 months, the cycle indicator just switched to “down”. This stage is characterized by economic indicators that, although generally still strong, have deteriorated or stalled. That is exactly what we are witnessing now. Consumer lending and housing sectors are slowing, M&A activity and corporate bond issuance are weak, and manufacturing activity is collapsing. And while some sectors, such as the labor market, remain relatively strong, there are also signs of a slowdown.
Overall, this framework gives us a clear signal of economic growth. teeth Due to the effects of sputtering and other factors, the weaknesses are becoming more widespread.
Morgan Stanley's cycle model is showing signs of weakness. Source: Morgan Stanley.
Now, a shift to a “recession” does not mean that a recession is imminent or that stock prices will collapse. This also does not mean that the economy cannot return to “expansion'' again soon, although the methodology makes it unlikely. What this means is that the economy has likely entered the final stage of its business cycle and is likely to slow further from here.
And this should raise alarms, especially since it contradicts some of the prevailing theories, such as that the economy is already past a slowdown, or that it will never actually slow down.
What does that mean for your portfolio?
Different assets perform very differently at different stages of the cycle. As you can probably imagine, recessions have historically been the worst times for stocks and high-yield corporate bonds, and the best times for cash and Treasuries. This is because when the economy slows, corporate profits generally suffer and debt defaults increase. Furthermore, when sentiment deteriorates, investors tend to demand higher risk premiums for holding risky assets, which lowers stock valuations and increases credit spreads. So, at the same time, cash and government bonds will benefit as investors flee to safer assets.
Now, for your portfolio, Morgan Stanley has some ideas on what to do when the index switches from expansion to stagnation.
beginning, play safe with it Across Asset class: Reduce allocation to stocks and increase allocation to U.S. Treasuries and cash.
Number 2, play safe with it At the inner Asset class: Swap US stocks for international stocks and risky high-yield corporate bonds for more defensive investment-grade stocks.
An example of a possible rotation to safer assets.Source: Morgan Stanley
Of course, every cycle is unique and looking at historical averages can be misleading. Furthermore, this framework does not say much about how severe the slowdown is likely to be. But if we do indeed enter the final stage of the cycle, things are likely to be even more treacherous than recent optimism suggests.
