The Next Phase of the Economic Cycle Begins

Important things are happening in the economy and markets.

After years of providing massive liquidity, the central banks are shifting gears. The Federal Reserve has been tightening for several years and other major central banks are either tightening or leaning toward it.

Also, in the last few months, the economic cycle moved to the late phase after being in the mid-cycle  sweet spot for a very long time.

Growth, inflation and interest rates increase during the late phase. The markets and economy become more volatile. Businesses and households start to feel the pinch from higher interest rates.

Housing appears to be taking the first hit from higher interest rates. After several years of making a solid contribution to overall growth, housing started 2018 slowly. Sales of new and existing homes are down as mortgage rates reached their highest levels in four years.

The late phase of the cycle also brings higher volatility in stocks and the economic data. Don’t overreact to short-term swings and noise. Wait for new trends to be established in factors that really matter to markets.

A key feature of the late phase of the economic cycle is that the Fed becomes concerned about inflation and tightens monetary policy enough to slow the economy, often causing a recession.

Traditional factors typical of the late stage of the economic cycle are pushing inflation higher, but several long-term forces are keeping a lid on inflation. Higher productivity and more global trade stifle price increases. Wage increases that are historically low for this stage of the cycle also prevent strong price increases. Most importantly, the debt overhang from the pre-2007 boom exerts strong deflationary
pressure on the economy.  Without these factors, wage and price increases already would be significantly higher.

Central bankers need to recognize the power of these anti-inflation forces and their limited tools to
stimulate recovery from a recession. They can’t overreact when inflation measures pop higher. They need to wait for a sustained period of significant inflation.

The mid-stage of this cycle lasted a long time, and this late cycle phase also could be extended if central bankers don’t overreact.

The late stage of the economic cycle usually isn’t a good time for investments that did well in the mid-cycle, especially bonds.

There’s a shortage of bond buyers now, because the Fed stepped back at the same time higher deficits are causing the federal government to issue more debt. Interest rates hit lows in July 2016 and have increased significantly since November. They’re probably going to increase more. This will continue
to be a bad time to own bonds issued anywhere in the world unless the economy falters, causing the Fed to return to its zero-interest-rate policy.

There’s still room for stocks to rise.

Rising real interest rates are a negative factor for stocks. But corporate earnings and cash flows continue to rise smartly. Tax reform increases corporate cash flow, and many corporations are using some of that cash to buy their stock or increase dividends. It looks like the net effect is positive for U.S. stocks, at least
through late 2018.

Non-U.S. stocks still offer better opportunities. Most countries are in an earlier phase of their economic cycles. They have higher potential growth for the next year or two and lower valuations than U.S. stocks.

Investments that benefit from higher inflation usually do very well in the late stage of the cycle. Such investments include commodities and inflation-indexed bonds. We own commodities and, in the coming months, are likely to increase our positions and add Treasury Inflation-Linked Securities (TIPS).

I’m hoping the Fed avoids overreacting to growth and inflation. That would extend this stage of the cycle and delay the day when we have to protect our portfolio from the next recession.