This mysterious economic cycle

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Where are we in the business cycle?

Economies move in irregular cyclical patterns. In a recession, consumers watch their wallets and businesses keep inventories and investments low. Asset valuations are falling. Everyone feels poor today and expects to be even poorer tomorrow.

Then, for some reason, things feel a little less gloomy. The family opens their wallets a little. Businesses realize that they need to replenish their inventory, update their factories, and hire more people. Investors realize the asset is too cheap and buy it. Over time, production, investment, and valuations will rise. recovery!

Excess items are starting to creep in and inventory is high. Capacity meets demand and then exceeds demand. Asset prices will be a little peaky. I still feel good, but time is getting late. Perhaps some small shock given by the central bank is enough to make businesses realize they need to lower prices and delay investment. Consumers will hesitate. The economy is in recession again.

This is too schematic. There are no public service announcements on the day the economy turns from recession to recovery, or from a ripe recovery to an overripe expansion. Best of all, no one rings a bell when a recession starts. Many people thought that the boom was still going on that day. It's hard to read cycles when you live in them. Since a typical cycle is about fluctuations in demand, it is even more difficult to read during supply and sectoral disruptions that ripple through the economy.

Since the impact of the pandemic, this cycle has been so puzzling that some think we are at its beginning, while others think we have come to its end. Here are Morgan Stanley's Michael Wilson's remarks Monday in a memo titled “The Return of Late-Cycle Strategies.”

We view this year as an extension of the late-cycle period often experienced when the Fed is expected to pause or reverse its hawkish policy stance. As is often the case in times like these, the widening of the multiple is ahead of the level at which macro fundamentals dictate fair value, and in order to keep the multiple high, growth that has not yet been priced in is necessary. burden for re-acceleration and additional policy support for…

Later in the cycle/more conservative [market] The factor is outperforming again. Specifically, we note that the factors of high cash, low debt, and low capital expenditure performed well last month. Since the stock market's local peak in late July, growth has outpaced both values ​​and the business cycle, even as interest rates have risen. Additionally, a broad set of early cycle winners have recently underperformed relatively.

In general, during economic recovery, stocks of companies that no one would touch during a recession, such as small and medium-sized enterprises, cyclical industries, high idiosyncratic risks, and large amounts of debt, do well. Both of these companies are the ones that benefit most from the economic upturn and are the ones that were most oversold during the recession. As the cycle ages and we approach recession, we need the opposite: companies that can remain stable or grow despite economic headwinds. As with large companies, staples and long-term growth stories are standard recommendations. Wilson and his team will also throw in industrial stocks. This is a type of cyclical stock that tends to perform best as the cycle gets longer.

Bank of America's Savita Subramanian takes the opposite side of the debate. On Monday, she wrote in a note, “Recovery Confirmed: Value > Growth, Risk > Quality, Small > Large,” that the team's cycle or “structure” metrics had turned from slump to recovery.

Indeed, the past few years have felt less clearly defined in terms of “cycles” due to the asynchronous ups and downs during and after the COVID-19 pandemic. However, our US regime indicators remain important in capturing trends in factors. For example, we saw a huge cap in the January-June recession, and growth and quality were right there. In August, the indicators improved for the second consecutive month, officially entering the “recovery” phase. Five inputs (inflation rate, GDP forecast, 10-year Treasury yield, ISM PMI, capacity utilization) improved, and three inputs (EPS revision, leading economic indicators, high yield spread) worsened.

This is a chart of the BofA Regime Indicator that summarizes the above data using Z-scores. Notice the small button connected to the right side (is there a similar head fake in previous cycles?):

Subramanian says now is the time to buy value and risk. She especially liked finance and high-dividend companies.

How is it possible that two talented strategists with access to the same data set would come to opposite conclusions about where we are in the cycle? Much of that seems to come down to methodology. is. Wilson focuses on market indicators, such as which sectors are outperforming, while Subramanian focuses on macroeconomic data. We think both factors are attractive, but both require time to understand the three factors we think are important: jobs, housing, and the highly uneven impact of the pandemic on the goods and services sector. not spent.

Starting with employment, it's strange to say we're early in the cycle, with payroll growth declining rapidly and the unemployment rate at 3.8%, up from a cyclical low of 3.4%. . Bottoming out in the unemployment rate usually occurs late in the economic cycle. This is because the labor market is a lagging indicator. Workers, unlike manufacturers and home builders, are less likely to be able to time themselves to economic fluctuations.

If the labor market looks solid late in the cycle, the housing market is largely shrugging. Houses are (some would say) disproportionately important to the cycle because they are large, influential, volatile, and widely owned. teeth business cycle). We wrote more about housing on Monday, but here's the general picture. “It's shrinking, but it's not as bad as it was.” Private housing capital investment in the second quarter decreased by 1.2% from the previous quarter. But last year's quarterly contraction was nearly 6%. Housing starts have increased this year as home builders rush to take advantage of the breakthrough.

Perhaps it's no surprise that the cycle feels disrupted after the huge sectoral shock of the pandemic. While the shift from goods to services is well known, what is less well known is the fact that real spending is gradually shifting back towards goods. The graph below shows the ratio of real personal consumption expenditure to goods and services. Turnover to spending has bottomed out:

The increase in goods spending coincides with the rise in manufacturing activity surveys, which fits the early-cycle interpretation.

When dealing with supply-driven sectoral shocks like the one we are experiencing, it is questionable whether aggregate metrics like Subramanian, which primarily capture changes in demand, will work well.

Wilson and Subramanian seek to situate the current moment within a standard circular economy framework. This is a worthwhile project. But you can't help but wonder the answer to the question: “Is this a recession, a recovery, mid-cycle, or late-cycle?” It may be “none of the above.” The pandemic may have thrown various parts of the economy off its normal trajectory, and it may take longer for normal patterns to re-establish. (armstrong & woo)

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