We believe the economy stays out of recession next year, but like a sprint to home plate by a base runner, the outcome is unclear and fundamental risks leading to higher levels of price volatility could be real.
Dec. 12, 2017 Commentary

Rounding Third and Heading Home - Business Cycle Maturing


It is that time of year when most pundits dust off the crystal ball and create their outlooks for the upcoming year. The purpose of this piece is to outline our thoughts regarding the economy and capital markets as we head into 2018. As can be imagined from the title, we believe the economy stays out of recession next year, but like a sprint to home plate by a base runner, the outcome is unclear and fundamental risks leading to higher levels of price volatility could be real.

Thematic View – From Where We Come

It is instructive to create a thematic tie to an annual outlook. Last year, our theme was Acceleration. We foresaw the economy, corporate profits and stock market all in an acceleration mode in 2017. That theme has played out. One factor which led us to embrace the acceleration theme was our opinion that the U.S. economic business cycle was maturing.

While not yet near recession, we believed the economy was approaching a boom phase and stock prices were possibly going to experience a “melt up” environment, driven by strong earnings growth. Our prognosis of an acceleration in economic activity to 2.5 percent gross domestic product (GDP) growth in 2017, coupled with higher stock prices, was based on historical standard. Unless something bizarre happens this month, our main forecast for 2017 – Acceleration – is now in the books.

Current Economic Environment – Where Are We?

It’s been a good run, for businesses and the stock market, over the last two years. Considering a longer-term view, the U.S. economy has been expanding since the Q2 2009 – the end of the Great Recession. The current business expansion is now the third longest of the last 10 cycles which have occurred over the last 72 years. According to the St. Louis Federal Reserve, national GDP has grown by 36 percent this business cycle, while corporate profits have grown by 58 percent.

The economic growth story, once the property of the U.S. and emerging economies, has spread globally. The “old men” of the global economy – Japan and Europe – are also generating positive GDP growth. The acceleration story has become global in its reach.

For much of the current cycle, the world’s central bankers maintained innovative, extremely accommodative monetary policies. The amount of liquidity the world’s central banks have created since 2008 has acted as a stimulant to economic activity, but perhaps has been most noticed in global asset values. Liquidity that is raised by central banks, which isn’t needed to finance economic activity, finds its way into financial and real assets (stocks, bonds and real estate). Excess liquidity tends to drive asset values up.

Now it appears the world’s economies have generated enough growth to maintain positive momentum without the crutch of central bank largesse. As of this writing, the Fed has increased interest rates on four occasions and has started the process of shrinking their balance sheet…all monetary tightening actions. The Fed has labeled these changes as actions to normalize monetary policies. We suspect the European Central Bank (ECB) won’t be far behind in instituting money-tightening actions.

Rounding Third and Heading Home – Business Cycle Maturing

Signs of economic maturity are appearing. Is the next economic recession, and consequently the next cyclical bear stock market on the horizon? As you may be able to tell from the title of this commentary, we believe the U.S. economy is sprinting towards home plate. While we don’t expect to see the start of a recession in 2018, the business cycle should continue to mature and risks of the economy entering a contraction phase sometime over the next 1-2 years seems a reasonable expectation.

Maturing economic cycles tend to be rolling affairs, not cliffs. Additionally, growth tends to accelerate. But, the peak in the cycle is becoming visible; stresses may be mounting. Take for example the following points of evidence regarding the maturity of the economic cycle:

  1. The U.S. jobs market has matured. With the official unemployment rate at 4.1 percent -- down from 4.8 percent a year ago -- most economists believe the jobs market has entered the “full employment” phase of the current cycle. Recently, small business owners were surveyed (NFIB survey) and asked if qualified employees were easy to hire. Only 12 percent of respondents indicated qualified employees were reasonably easy to find. Typically, a mature jobs market eventually leads to rising wage rates, as employers vie for good, qualified workers.  We suggest rising wage growth rates will be part of 2018’s economic story, which in itself can lead to higher pressure on inflation. 
  2. A mature jobs market leads to strong consumer confidence and solid consumption activity.  For much of the current cycle, consumers have been paying down debt or deleveraging their balance sheets. This process has stopped. Over the last year, savings rates have declined and the use of revolving credit (credit cards) by consumers has risen. Consumer discretionary spending has risen by 4.5 percent over the last 12 months. This is a reasonable but not frothy growth rate. The days of the frugal consumer seems to be yesterday’s story.
  3. Non-residential fixed investment spending has increased by 4.4 percent over the last year.  The average growth rate of capital spending in 2017 has been the strongest our economy has experienced in three years. We expect capital expenditure (CAPEX) growth to rise further in 2018, partially in response to the damage done by the two hurricanes in 2017. Additionally, higher oil prices are helping CAPEX growth. But beyond those two issues, we are seeing signs of strong spending growth in both information processing equipment and industrial equipment areas. The growth rate in these two subcategories is the highest we have seen in five years. These appear to be sustainable trends moving into 2018.
  4. Monetary policies are now becoming restrictive rather than simulative. As noted above, the Federal Reserve has raised interest rates on four occasions over the last two years. Additionally, the Fed has started to reduce the size of their balance sheet. Indeed, the ECB has indicated their desire to start moving down the monetary process path the Fed is currently blazing. We expect to see a reduction of $1 trillion in liquidity stimulus from central banks in 2018, as compared to 2017. Excess liquidity has acted as the ammunition for higher asset values for the recent past. We expect price volatility in many asset classes will increase as 2018 unfolds.
  5. The monetary changes at the Fed and other factors has led to a flattening of the U.S. Treasury yield curve. Historically, the relationship between long- and short-term interest rates has become rather flat prior to recessionary environments. Typically, long-term interest rates are higher than short-term rates. Prior to the last number of recessions, this relationship has inverted, where short-term rates are higher than long-term rates. Currently, that relationship is a mere 0.58 percent, down from almost 3 percent at the end of the last recession. If the Fed continues to raise short-term interest rates next year (we suspect this will occur) the yield curve threatens to fall into an inverted position.
  6. Stock prices have risen dramatically over the last two years. The S&P 500 is up 42 percent since setting the interim lows on Feb 11, 2016. This index is up 21.1 percent on an annualized basis since that low. Typically, over a long period, the index has been up about 8 percent per year. Stock prices have been melting up for the last two years. This is typical of stock market activity prior to a recession. Prior to the last four business cycles, stock prices have generated returns of 42.3 percent, on average, for the 2.5 years prior to those recessions.

All of the above considerations point to an economy which, while growing nicely, has entered a boom phase. This is a phase which typically front-runs an economic recession. While we aren’t calling for a recession as our core outlook for 2018, it is important to understand where we currently stand regarding the U.S. business cycle. Bluntly, the cycle is showing signs of maturity.

Our Core Case – Economic Growth Continues with Rising Risks 

So, the current business cycle appears mature. The current environment is reminiscent of past boom periods when growth is strong and broad. In the end, we believe the environment in 2018 will be positive from an economic standpoint. From a numbers standpoint, we are calling for:

Economic Growth Continues with Rising Risks Table

As can be seen from the above, our outlook is calling for a continuation of growth acceleration in GDP, inflation, corporate profits and interest rates. We are calling for the Fed to raise short-term interest rates on three occasions in 2018. This will lead to a further flattening of the yield curve, and may indeed lead to a slight inversion of the 2/10-year treasury curve.

When will the next recession take place? The tools we have used for quite some time tell us that a recession isn’t imminent, but the business and market cycles appear mature.

  • The yield curve is still positive. While a flattening has taken place, and will probably continue to take place, short-term rates are still lower than long-term interest rates.
  • Credit spreads (the difference between junk-bond yields and high-quality yields) are rather narrow. Typically, the economy risks falling into recession when these spreads are very wide.
  • The six-month rate of change of the Leading Economic Indicators is currently very positive at +5 percent. Over the last 10 business cycles, the economy has never fallen into recession when the reading of this critical data is this high.
  • The Fed Funds rate is still lower than the 10-year Treasury note yield at its low point for this cycle. According to the folks at Wells Fargo Economics, recessions, on average, have occurred in the past 17 months, after Fed funds rates rise past the low point of 10-year Treasury yields. We suspect this may occur next month. If this occurs, history tells us a recession may indeed become a core outlook sometime in 2019.

Consequently, the weight of the evidence tells us that the end of the current business cycle (and the start of the next recession) appears to be more of a 2019 event rather than 2018. We are not currently concerned the economy will slip into a recession over the next year. Beyond that, the forecasting sky becomes much cloudier.

We need to address the potential of the tax policy change legislation coming from Washington. As the plan is currently being discussed, it appears to us that the plan could stimulate additional GDP growth. Econometric models are showing GDP growth at 0.3 percent higher, per year, over the next five years with the passage of the tax plan. The additional fiscal stimulus may drive the Fed to tighter monetary policies than would have otherwise been the case, in the fear of an economic overheat.

Additionally, if the bill is passed as it currently stands, it appears the Federal deficit will probably widen by a meaningful amount over the next several years. This tradeoff highlights one of my economic maxims – “In economics, there are no solutions, only tradeoffs.”

Our Core Case – Stock Markets Continue to Rise in Price – With More Price Chop

Now that we have put forward our core economic outlook, what of the U.S. and global stock markets? What should investors expect of market returns in 2018 and beyond? First, stock prices should continue to grind higher through much of 2018. This continued upward push in prices may be driven by strong earnings growth, but tempered by a more restrictive monetary policy. 

It is important to remember that stock market values are currently high, irrespective of the measures used. By definition, valuations are high because positive economic and business condition expectations are also high. If something unforeseen occurs to significantly challenge those positive expectations, stock prices may swoon. The degree of the price swoon is driven by the degree of overvaluation.

What may disappoint investors next year, unleashing a reasonable correction in stock prices? We highlight two wild cards – Washington and inflation.

Investors are expecting passage of a meaningful tax package, leading to lower tax rates for businesses.  Additionally, the current administration tends to be unpredictable in its actions and words. Something currently unknown could occur in Washington which places current investor confidence into jeopardy. We currently believe a tax package of sorts will be passed. Depending on the details included in the final package, we envision corporate earnings will be positively impacted in 2018 as compared to growth in 2017. But to a certain degree, we believe the tax package is already built into current stock prices.

The other noted wildcard next year may indeed be the arrival of a more threatening upward grind in inflation. This could lead to an aggressive tightening of monetary policy by the Fed, which may then be mimicked by the ECB. Short -term interest rates could rise more than expected, pushing the yield curve closer to inversion.

Stock markets could wobble as we experience the first 10+ percent downdraft in stock prices since 2016, driven by either of these troubling scenarios. But in the end, we remain positive, in general, towards the stock market for 2018.

Summary and Closing Thoughts

We believe next year will contain both positive and troubling events. Isn’t that always the case? If our view of Rounding Third and Heading Home holds water, then we have to start thinking of stock prices running into fundamental economic headwinds next year. As mentioned above, the Standard &Poor’s 500 index rose by 42 percent in value over the two years prior to the last four recessions, on average. Since the lows in February 2016 the S&P 500 is up 42 percent in price. 

Why do we focus on the business cycle, providing information as to trends regarding recessionary risks?  Over the last four business cycles, the attendant average price change in the S&P 500 has been -36 percent. Being aware of economic trends and business cycles has been worth the effort. We provide this information in an effort to make our clients aware of building risks and opportunities.

That being said, the practice of investment management is a long-term process. Keeping one’s eye on the business cycle is important for shorter-term risk management practices. The stock market has generated positive returns 57 of the last 77 years. Stocks have handed investors positive returns 74 percent of the time since 1940. For investors who have a time horizon of more than five years, the track record of positive returns is even more impressive.

We have carried a positive view towards the markets since we first made our call a number of years ago that we are experiencing the fourth secular bull market in stocks since the year 1900. We stand by that call on a secular basis. However, we harbor building concerns about the equity markets from a cyclical standpoint.

If you have any questions regarding our thoughts here, please feel free to contact your wealth advisor.


This commentary is limited to the dissemination of general information pertaining to Mariner Wealth Advisor’s investment advisory services and general economic market conditions. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. There is no guarantee that any claims made will come to pass. The opinions and forecasts are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information that this opinion and forecast is based upon.

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