UBS: Investing in a mature cycle

Where are we in the business cycle? This is always one of the most important questions for asset allocation, but it is becoming even more relevant as this historically long expansion trudges forward. In May, the US economic expansion became the second longest in post-war history,1  which inevitably brings into question how much longer it can possibly last. Of course, the answer to this question can only truly be known ex-post—we can only be sure where we stood in the cycle at any given time once the expansion ultimately ends in the form of a recession. What we can do now is look at historical cycles and compare current economic and financial market data to what has preceded recessions in the past. In this Macro Monthly we discuss what the past tells us about where we currently are in the cycle, what could shorten or extend this cycle, and how we are positioning our portfolios based on these assessments. 

Why the focus on the US business cycle, as opposed to the global expansion? This is a valid and important question. The expansion has been longer in the US given mini-contractions in Europe and Japan earlier in the post-crisis period. Many of the emerging market economies also suffered a dip in activity in 2014 and 2015 amid a sharp decline in Chinese manufacturing and in commodity prices. Moreover, recent global economic performance has been synchronized; it is reasonable to imagine some decoupling of the rest of the world from a mild recession in the US. That said, the US remains the world’s largest economy and importantly, the world’s largest importer. A sharp cutback in spending by US consumers and production by US businesses will impact countries and regions with large trade surpluses, including Europe, Japan and China. Just as important are financial linkages. Dollar assets make up half of the investable world; a sharp decline in US asset prices will inevitably lead to de-risking in other areas of the world, even if there is some rebalancing outside the US. And the US dollar remains the world’s global funding currency. Tighter financial conditions in the US spread to those countries that fund in dollars; recent weakness in emerging markets is a useful reminder of these ties. In short, while there may be some decoupling amid a US downturn, it is unlikely that non-US economies and risk assets would perform strongly.

Mid or late cycle?

An oft-cited refrain, repeated in recent years by former Fed Chair Janet Yellen, is that ‘expansions don’t die of old age.’ While we agree, we do note that the longer economic cycles last, the more time there is for the underlying conditions to build that lead to an overheating and Fed tightening that triggers an end to the expansion, either via inflation or financial market imbalances. In some ways today looks very late cycle.

The unemployment rate is exceptionally low, and history shows that typically labor markets do not remain this tight for long before a recession hits (see Exhibit 1); too hot a labor market implies reduced capacity, higher inflation and encourages tighter monetary policy. Indeed, labor market tightness along with gradually rising wages and inflation are prompting the Fed to remove accommodation, both via unwinding its balance sheet and rate hikes. And the yield curve continues to flatten (see Exhibit 2), which is the market’s way of telling the Fed that expected near-term rates are closing in on perceptions of the long-term average rate.

On the other hand, there are reasons to think that this cycle still has plenty of room to run. While wages and inflation are rising, they are hardly breaking out to the upside. The Fed is tightening but at an extremely slow pace—the Federal Funds rate is still negative on a real basis (1.50%–1.75% policy rate minus an assumed 2% inflation), while overall financial conditions, measured via broad indexes or bank willingness to lend, remain easy. US profit margins, which typically decline late cycle, have been rising.

Here you can download the full Macro Monthly.