CFA Society Singapore
SINGAPORE (Oct 6): The US or global economy appears unlikely to be heading to a recession, despite indicators pointing to a late phase in the business cycle and with the threat of monetary policy tightening looming in the horizon.
This is what David Lafferty, chief market strategist, Natixis Global Asset Management, expects because he says the traditional business cycle framework may no longer be the best way to analyse trends for signs of recession.
“It is often pointed out that the post-GFC recovery has been the most anaemic in history, averaging just 2.1% annually since Q3 of 2009, while typical US recovery/expansions average 3%–5%,” says Lafferty.
This means normal business cycles may not play out prominently with recovery and expansion phases lasting longer as fewer excesses have been built up in the system, Lafferty notes.
In summary, Lafferty says the business cycle is now “less useful than before".
Still, he insists the US economy is showing three signs of being in the “late cycle”.
The first being the flattening of the yield curve that started from late 2013.
While the yield curve has predicted nine of the last five recessions, Lafferty questions whether the yield curve reflects equilibrium market rates.
“With the Fed and other central banks holding rates down artificially, we believe this indicator may be even less accurate today,” he adds, “In spite of these caveats, the flattening yield curve is still a late-cycle behaviour.”
The second sign is the high level of credit creation. During expansion, use of debt grows as an increasingly positive outlook justifies higher debt levels. This is where the economy is at today, notes Lafferty.
“While historically low rates are likely driving bond issuance in general, the explosion of corporate issuance globally is certainly indicative of late-cycle behaviour,” says Lafferty.
The third sign is the stretching of asset valuations as investors utilise the economic outlook to justify higher prices.
“With traditional equity and corporate credit valuations moderately above their long-term averages, we see still another hallmark of late-cycle behaviour,” says Lafferty.
So when does this “late cycle” turn into a recession? Lafferty points towards looking at the composite measure of US Leading Economic Indicators (LEI) and the jobs market. The month-on-month change has dropped into the negative twice this year, but still remains above 0.0% on a year-on-year basis.
“Since 1960, there has been only one instance when the y-o-y LEI has fallen below zero without the US immediately entering recession 1967,” says Lafferty.
“There have, however, been several near misses, where the LEI plunged but didn’t go negative, and no recession materialised (1996, 1999, 2003, 2013),” he adds, stating this is analogous to where we are today.
The US jobs market is also an indicator, as US Labor Force Participation has rebounded since bottoming out in Sept 2015.
“As a result, unemployment has stabilised but this understates the strength in the labour market as now more people are working or looking for work,” says Lafferty.
“So the US labour market still appears to have some upside left, which should bolster overall aggregate income and spending,” he adds.
Two major sectors of home construction and auto manufacturing too have room to grow according to Lafferty, having no oversupply.
While monetary policy appears to trigger recessions, Lafferty says it is "over-restrictive" monetary policy that causes the economy to roll over.
“Even though we expect the Fed will raise rates again in December by 0.25%, we believe this is properly categorised as “less accommodative”, and hardly restrictive,” says Lafferty.
Finally, with global recovery and expansion being asynchronous and the US and other economies being at different points of the business cycle, this may help stave off a recession.
“This “diversification” across the cycle has resulted in a weaker expansion overall, but it may also prolong the growth phase,” says Lafferty.
Nevertheless, Lafferty cautions investors to look out for the following signs as a prelude to a recession. These are sustained increase in initial jobless claims or other components in the LEI, material signs of inflation that leads to a more aggressive Fed, and a risk-off shock from an unexpected US election outcome.