economic perspective

July 2017

  

The current bull market, at 100 months, is the second longest since 1928. Despite some end-of-cycle warnings, the current expansion is on its way to becoming the longest in history. Thomas Dillman, President of Mutual of America Capital Management LLC, explores some of the key signs that typically manifest themselves prior to the onset of recession—a moment that is generally accompanied by the end of bull markets.

Our June edition of Economic Perspective focused on a few of the longer term structural problems the domestic and global economy will have to face. We also reaffirmed our expectation that the current expansion could continue for another year or two at a slow, but relatively steady, pace. The basis for this outlook is that part of the explanation for the extended duration of the expansion to date is that it has been slow and, therefore, has not developed any dramatic excesses characteristic of the end of economic cycles.

New home sales, for instance, have only reached the levels typical in the late 1980s and early 1990s, and at an annualized rate less than half that of the peak attained in 2006. Granted, that peak was fueled by extravagant lending and borrowing, an example of excess that is not present in the current expansion. The worst that can be said is that this economic cycle was generated by unprecedented and unconventional monetary stimulus, which some might consider as excess. It is our opinion, however, that without such monetary policy, the depth of the Great Recession would have been far lower and the path to recovery much longer.

That said, this cycle is long in the tooth. Unless it gets a boost from fiscal stimulus in the form of tax cuts or reform and infrastructure spending, we likely are closer to the end than to the beginning of the cycle. Most of the signals that typically manifest themselves prior to the onset of recession have long lead times before recessions occur and, as such, give fair warning to investors. Unfortunately, investors sometimes ignore the signs, devising clever explanations of why "this time is different." Other mistakes investors sometimes make are to either get out of the market too early, or wait too long to do so. For our purposes here, we will discuss the anticipatory signs in order to understand how and why cycles end.

1. Negative Yield Spread Between the 2-Year and 10-Year Treasury Bonds

When short-term interest rates rise to levels above those of long-term rates, economists and strategists refer to such a situation as "a negative yield curve." Every post-WWII recession has been preceded by a negative yield curve. This condition usually arises because the Federal Reserve raises short-term rates in order to curtail rising inflation in an overheating economy, one in which the demand for goods exceeds the supply. While few would argue that the current U.S. economy fits that description, the Fed is in the midst of a slow increase in short-term rates. Its purpose is to raise the Fed Funds rate above the 0% to 0.25% band, over which it's been held for the past six years, to a more normal level—currently targeted at 3% by the end of 2019. This action, along with a planned reduction in the size of the Fed's balance sheet is an attempt to unwind the quantitative easing program in place over much of this expansion.

The recent result of the increases in the Fed Funds rate, now targeted in a range of 1.0% to 1.25%, has been to narrow the difference in rates between short- and long-term rates. The so-called spread between the 2-year and 10-year Treasury notes has been narrowing for the past year. As of this writing it had shrunk to less than 100 basis points from a peak of more than 250 basis points in 2014. The decline has been slow, as has the expansion itself. But further declines toward a zero or negative spread would be a leading signal of recession. The good news is that the lead time to recession following the advent of a negative yield curve typically is anywhere from 9-to-18 months.

2. Corporate Profit Margins Decline

A contraction in corporate margins is another leading indicator of recession. The underlying dynamic that leads to margin compression is rising costs, especially for labor as the supply of workers dwindles. With an unemployment rate approaching historical lows, the supply of labor appears smaller. While S&P 500® profit margins remain steady near historical peak levels, corporate profit margins as reported in the National Income and Product Accounts (NIPA)—representing all of corporate America—show a meaningful decline. NIPA profit margins always lead S&P 500® profit margins, and profit margins for the S&P 500® generally peak about 75% of the way through an expansion. The implication for an eight-year-old expansion is that it could last for another two-and-a-half years. That calculation suggests a healthy cushion for further expansion, but remains a signal that expansion is approaching its limit.

3. Various Indicators Registering All-Time Highs

A.

Auto sales peaked in this cycle at the end of 2016 at an annualized rate of 18.2 million vehicles, a level exceeded modestly only three times since 1987. Two of those occasions preceded recessions by 18, 3 and 30 months, in 1989, 2001 and 2005, respectively.Auto sales also have plateaued near historical highs of 16.5 million vehicles and production schedules have been cut back. Given the vast supply chain of capital equipment and parts manufacturers, as well as the auto lenders that feed the auto industry, a slowdown in auto production has a potentially significant impact on the economy overall. That said, the disparity of lead times to recession for auto production suggests that this indicator is not a very timely forecaster.

B.

The May unemployment rate was 4.3%. Only once, in 1987, did the unemployment rate fall below the current level. All three recessions over the past 30 years were preceded by a trough in unemployment, with lead times to subsequent recession of 12-to-18 months. Of course, it is logical that when unemployment troughs and begins to rise, the economy is in a slowing phase.

However, the unemployment rate in this cycle is still declining as far as the last data point indicates. One twist in the unemployment rate in this cycle is that the labor participation rate is much lower than in previous cycles. If those individuals that until now have indicated they are not interested in looking for a job were to begin to re-enter the labor force, the unemployment rate would rise. That might not necessarily signal a forthcoming recession, but rather a second wind for expansion. Confirmation of this latter scenario would be a quick absorption of those new entrants into the workforce, and a continuation of a decline in the unemployment rate.

C.

The Index of Leading Indicators incorporates a number of economic and market variables—such as new orders, building permits, unemployment claims, and even the price of the S&P 500®—into a composite which has shown a high correlation to ebbs and flows in the economy. At peak levels it tends to precede recessions by anywhere between nine and 18 months. Currently, the leading indicators are running at all-time highs but have actually accelerated recently.

D.

Consumer confidence is currently at a higher level than all prior peaks except 2000. Consumer confidence peaks typically precede recessions by between six and 12 months. This measure just came off its high for the cycle, but that does not necessarily mean it has peaked.

E.

Corporate yield spreads (the difference between classes of corporate bonds and Treasury bonds of similar maturity) are near all-time lows. This condition signals confidence by corporate bond investors that credit conditions among corporations are healthy and that the economy is not presently at risk.

There are also two structural reasons why corporate yield spreads might be so low: (1) domestic and foreign investors are seeking as much yield as possible in what continues to be an extremely low global interest rate environment, though one where U.S. rates are generally higher; and, (2) foreign investors may be seeking security in U.S. bonds given the turmoil in many regions of the world. Investment-grade and high-yield bonds are currently at spreads over Treasuries and very near their lows for this cycle recorded in November 2014, as well as close to the lows that prevailed for most of the period from 2004 to 2007. As suggested by this latter extended timeframe, tight spreads could be maintained for a long time if underlying economic conditions remain sound.

Based on the limited data available, the only reading on the lead provided by this measure came prior to the last recession, and was about nine months. However, during the current expansion, these spreads have actually widened significantly on two occasions when economic prospects seemed to be deteriorating. Thus, as a precursor of recession, corporate spreads offer limited insight. Nevertheless, credit spreads can widen dramatically when recession occurs. In 2008, high-yield spreads widened from a spread over Treasuries of around 250 basis points to 1,650 basis points!

Keeping an Eye on Other Factors

Recent events that suggest caution, despite the evidence cited above that there seems to be plenty of life to this extension, include falling oil prices, a declining 10-year Treasury yield and another bout of declining inflation after hitting the Fed's goal of 2%. Most observers believe that the recent decline of more than 20% in the price of oil is the result of excess supply, and there's a lot of evidence to support that claim. However, others suggest we may be experiencing a slowdown in demand as China begins restricting credit in order to slow growth, which in turn would exert downward pressure on global growth. Declining yields on the 10-year Treasury bond in the face of Fed tightening, and rising short-term rates, suggest that bond investors are skeptical about continued growth and the extended euphoria that has gripped the stock market. Finally, the general lack of sustainable inflation, whether in the U.S., Europe or Japan, argues strongly that deflationary factors of a structural nature—such as excess supply and capacity for almost any commodity or product, global trade which competes on price, and the productivity enhancements provided by continual technological innovation—are conspiring to undermine pricing flexibility in all but a few industries. These factors, if they persist, may alter the Fed's perspective on raising interest rates over the near term. So far, the members have given little indication they are willing to alter their current plans.

Notwithstanding these caveats, there are plenty of factors signaling that the economy is in relatively good shape. While inflation may be a problem for corporations in limiting pricing power for their products, the lack of pricing power accrues to the benefit of their customers. Labor costs by some measures are running at 2.5%, and on others look to be advancing at closer to 3.5%. In either case, consumer spending continues to advance at a slow pace of 2.5% on an historical basis, but in line with labor costs. The savings rate remains at an elevated 5% for most of the expansion, indicating that consumers are cautious—an observation supported by another that credit extension (outside of autos and student loans) remains constrained. Home sales continue well below previous cycle peaks as a result of limited supply, which in turn has pushed up prices and thus reduced affordability. Rising interest rates have also begun to impinge on affordability.

Nevertheless, pent up demand and acceleration in household formation augur well for continued increases in home sales over time. Corporate capital spending remains secondary to share repurchases and dividend increases among publically traded companies, but there are signs of an incipient pickup in the willingness by companies to invest more in their businesses, a necessity for longer term growth. Finally, as noted previously, capacity utilization has continually run below the 80-85% threshold that traditionally signals the beginning of a mishmash between demand and what corporations can provide without sparking inflation.

Bull Markets Don't Last Forever

As we've repeatedly stated over the years, bull markets don't die of old age. They die when expansion is interrupted by recession. The current expansion, at 96 months, is the third longest since 1928, exceeded only by the one from March 1991 to March 2000 (120 months) and the one from February 1961 to December 1969 (106 months).

The current bull market, at 100 months is the second longest since 1928, exceeded only by the one that lasted from December 1987 to March 2000 (150 months). Despite some end-of-cycle warnings, the current expansion appears on its way to becoming the longest in history. Whether the bull market sets a record depends upon how long the expansion lasts. If this expansion becomes the longest on record, any recession likely is at least two years away. This would suggest that the bull market may last another 12 to 24 months.

However, such comparisons to history are no guarantee that our current experience will mirror the past. This cycle is unique compared to those of the past because it has been sustained by extremely unconventional global monetary policy that injected somewhere between $15 trillion to $18 trillion of liquidity into the global economy—much of which ended up being funneled into stock and bond markets. It is also slower and significantly less robust. As the Federal Reserve implements its policy of slowly reducing its stimulus, and eventually Europe and the United Kingdom follow suit, investors will need to carefully track the leading indicators of recession.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.



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