This Time is Different
The current business cycle – the time since the end of the last recession – is now the longest cycle on record, according to the folks at the National Bureau of Economic Research (NBER), who have been keeping records on U.S. economic cycles since 1854.
Facts concerning U.S. economic expansions and subsequent recessions:
- Since 1854, the United States has had 33 business cycles with each expansion lasting an average of 38.7 months. By comparison, the current expansion is at 121 months, again, the longest on record.
- Business expansions have been getting longer. During the last four expansions (since 1982), the average expansion has been 101.5 months.
- The change in expansion duration is dramatic. If we look at the eight business expansions from the end of World War II to 1982, the average business expansion lasted 44 months or a little less than four years.
What has happened to the U.S. business cycle? Why are periods of economic expansion longer, by far, than they were during the previous four decades? Taking this discussion one step further, do we see indicators in the current cycle that lead us to believe the cycle will continue for some time or is the current business expansion at risk of imminent collapse? Looking at business cycles in addition to economic signals, which I discuss later in this commentary, gives us insight into the potential timing of a slowing economy and future recession.
What Has Changed
To understand why the U.S. economic or business cycle has been much different in duration than in the past, we need to understand how the U.S. economy has evolved and changed during the last 50 years. The lengthening of the business cycle started following the long, deep recession of the early 1980s.
To start off, we need to understand why recessions occur. They occur either because of a significant imbalance in the economy (too much or too little of one thing or the other) and by debt or credit imbalances. Secondly, we need to come to grips with the idea that the U.S. economy and what drives economic growth has evolved or changed during the last few decades.
Prior to 1980, the U.S. economy was structurally different than it is today. Manufacturing output used to represent a much larger portion of economic output than it does today. Recessions used to be tied to “inventory cycles.” That just isn’t the case today. Just-in-time inventory systems have come of age, which help to keep inventory levels in check. Manufacturing represents less of total macro output than was the case 40 years ago, because the service sector of the economy now represents a whopping 70 percent of output, according to The Economist.
Another factor is the makeup of the workforce of today compared to 40 years ago. The workforce used to be much more unionized than it is currently. The lessening of unionization of the private labor sector has increased business flexibility, or the ability to hire and fire workers more readily, which helps smooth the volatility of business cycles.
Lastly, the true nature of business investments has changed over the decades. Business investment is still running around 14 percent of overall gross domestic product (GDP), according to The Economist, which is in line with the long-term average. However, businesses are now spending more on intellectual property (IP), which now accounts for about one-third of overall business investment spending compared to about one-fifth in 1980. Investment in plant and property as a percentage of overall business investment spending has receded during the last 40 years, according to The Economist. The rate of investment spending in IP tends to be more stable, or less volatile, than spending on plant and equipment. This trend has led to lower swings in overall business spending, which helps soften volatility in overall economic activity.
So, structurally the U.S. economy is now significantly different than was the case when I got into the investment business in 1979. Consequently, business cycles have become much more extended, and recessions have occurred much less frequently than was the case prior to 1980. The typical four-year “boom” followed by a one-year “bust” has been transformed into eight years of moderate growth followed by one-year bust.”
I don’t believe the timing of the new business cycle will change dramatically, as I don’t think the economy will return back to the days of 1950-1970 when manufacturing drove overall business activities. The extended cycle has been with us for the last four business cycles and won’t go away easily.
The Current Boom
As stated earlier, the current cycle has passed its 10-year anniversary, according to the NBER. The cycle appears to be rather mature, as the jobs market, the investment markets and now Federal Reserve policies have all entered phases reminiscent of previous mature “boom” phases of the business cycle.
As was outlined in last month’s economic outlook piece, it is typical for the Fed to start an interest rate reduction cycle prior to the ending of a business cycle and the start of a recession. The Fed has announced a reduction in the federal funds rate to 2.0 – 2.25 percent. In addition, the Fed’s press release following its meeting suggested that the process of quantitative tightening (QT), or the reduction in the size of their balance sheet, has ended. The Fed’s actions indicate a desire on its part to increase financial liquidity through the banking system. Again, this is typical activity of the Fed a year or two ahead of previous recessions.
Why has the Fed taken these actions? We have been highlighting the view that, while overall economic growth has lessened over the last few months, overall growth remains reasonable. Additionally, inflation appears rather tame. Some say the Fed wants to take out an “insurance policy” against continued economic weakening. The Fed Funds interest rate used to be 2.5 percent. If a business wasn’t going to make an investment at 2.5 percent interest rate, are they now going to do so at the current 2.2 – 2.25 percent? I doubt it. If the Fed lowered rates specifically to cheapen financing costs, I think it will be disappointed.
The federal government is running huge government deficits, so the Fed didn’t lower rates to offset government fiscal spending constraints. I think the Fed reduced rates, in part, because of the value of the U.S. dollar and foreign economic activity.
Foreign economic growth has been very weak. Some believe Germany, as an example, is currently flirting with recession. Central banks in Europe and Japan wish to launch new rounds of monetary expansion. To do so without the U.S. Federal Reserve leading the way would probably lead to high levels of dollar strength compared to foreign currencies, which would hurt our trade deficit and weaken export growth rates from the United States. I believe this is one of the justifiable reasons that the Fed reduced interest rates.
Lastly, certain segments of the yield curve – the relationship between short- and long-term interest rates – has inverted. That is, short-term rates are now higher than long-term rates. This is an unusual event which, in the past, has signaled that a recession was going to occur sometime in the not-too-distant future.
Will the Fed continue to reduce rates? In his post-announcement, Chairman Powell stated that the rate reduction was a “mid-cycle adjustment,” according to the Wall Street Journal. This news disappointed those who were looking for confirmation that this was the first of a number of expected rate decreases. That being said, depending on a number of variables, I believe that the Fed may reduce interest rates one more time this year.
I am focused on three major factors:
- Overall GDP growth rates. If GDP growth during the third quarter shrinks to less than 2 percent, the Fed may use this as a reason to reduce rates again.
- Jobs market report. The economy is creating fewer jobs, on a monthly average this year than during 2018, according to the St. Louis Federal Reserve. If the jobs market continues to lose vibrancy, expect the Fed to reduce interest rates.
- Small business sentiment. If, through the remainder of this year small business sentiment starts to show reasonable levels of weakness, I suspect the Fed will reduce interest rates.
I’m sure the Fed will consider other factors, but from a standpoint of sustaining the current cycle, I suspect the above three factors may be key. Also, remember that the Fed’s interest rate reduction policies won’t positively affect overall economic activity until sometime next year. In the meantime, we will wait and see the Fed’s next move.
What May Be in Store
The final answer to the questions mentioned above – are we on the cusp of the economy entering a recession – I have to say the answer is “no.” While the cycle appears mature, the majority of indicators we rely on are telling us that a recession isn’t in the cards this year and perhaps not for next year.
Don’t get me wrong, significant economic risks are still present. Recessions used to cause excesses, including housing busts, oil price spikes or industrial contractions. We don’t see those risks currently present.
We do see economic risks, including:
- As trade policies lean hard on China, globally interconnected firms may be pressured to rapidly and radically change production channels and sourcing. This climate pressures profit margins and raises economic uncertainties that, in turn, lower business sentiment and investment growth.
- A highly levered corporate sector of the economy, because debt as a percentage of national GDP is the highest we have seen, according to Ned Davis Research (NDR) data.
- China’s economic growth rate is rapidly decelerating according to some accounts, and a cornered tiger is a dangerous one.
- Nationalism is running hard around the world, not only in the United States but in Europe, India and China.
- The United States continues to be politically divided, as we wrestle with the role of government. There are individuals on both sides of the radical fence who don’t see the redeeming value of the “middle road.” In many avenues in life, the radical solution is seldom the best one.
These points all highlight a building sense of instability. Economically, if people sense instability and a higher than normal level of uncertainty, they tend to freeze and don’t transact, which leads to slower overall economic momentum.
We have long held the view that overall GDP growth will be lower this year than last. As we enter the second half of the year, we stand by that view.
“America’s Expansion is Now the Longest on Record,” The Economist, July 11, 2019.
“For How Long Can Today’s Global Economic Expansion Last,” The Economist, July 13, 2019.
“Non-Financial Business Debt as a % of GDP,” Ned Davis Research, 2019.
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