Despite the best efforts of global central bankers, the business cycle has yet to be repealed. So from time to time I like to look at a series of indicators I use to gauge where in the business cycle the US economy is so I might get a sense of how close we might be to the next recession.
Our present cycle is aging and is now in its ninth year. This compares with an average post–World War II cycle of roughly five years. Of concern to me is the potential for labor markets to run too hot. Wages have not taken off yet, but the US Federal Reserve is watching closely for that possibility. September’s US employment report showed a definite uptick in wage pressure, but given possible distortions owing to recent hurricanes, investors should watch the data carefully for a few months in case the uptick turns out to be an anomaly. Surging private sector credit growth is a cause for concern, in my opinion, with debt-to-asset levels approaching peaks last seen in 2007, on the eve of the global financial crisis. A surge in credit utilization is typical late-cycle behavior.
Are we in the midst of an asset bubble? Probably not, though both equity and credit markets are historically quite expensive. Many housing markets are pretty rich, as well. However, cryptocurrencies, such as Bitcoin, could qualify as a bubble, in my view. Looking further at financial excesses, I’m worried about the pace of mergers and acquisitions (M&A) activity. In addition, I’m concerned about the premia being commanded above market prices to get deals done. In my experience, the takeover premiums being paid today are running much higher than average, with some transactions commanding as much as 40% above pre-deal levels. This too is emblematic of late-cycle activity.
We watch the shape of the yield curve because an inversion of the curve has preceded the last seven US recessions. I don’t see long-term interest rates falling below short-term rates under the current regimes at the Fed and European Central Bank. The curve is quite flat, though it has steepened a bit lately, and this suggests the market believes the uptick in growth we’ve been experiencing recently might not last a year or two down the road. Interestingly, there’s a school of thought that says yield curves tend not to invert during periods of very low interest rates. That has been the case in Japan, where the last four recessions weren't preceded by inverted curves. However, each recession since the late 1960s was preceded by an inverted curve.
Among my biggest worries is the falling profit share of GDP. Typically, when corporate profits fall as a percentage of the overall size of the economy, it's a sign of potential trouble and tends to foreshadow weakening capex and job growth down the road.
To sum up, while we don’t appear to be in near-term danger of recession, there are growing indications that we're late in the business cycle. Markets tend to become most enthusiastic late in the cycle, and we’re seeing clear signs of that today. That’s why I encourage investors to keep capital preservation strategies top of mind.
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The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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