Where are we at this stage of the economic recovery?
That is a more difficult question to answer than it first appears. Traditionally, we have thought of the business cycle in a formulaic way. The usual progression is: prior recession ends as negative sentiment troughs at unsustainably low levels; then, as prior imbalances and excesses are worked off, business activity finally picks up from these low/underutilized levels. As growth expands, employment and spending expand as well, in a snowball effect of positive momentum. Eventually, the cycle matures and the easy growth becomes more difficult to come by. At that point, you begin to see firms stretch for growth by adding leverage/debt and engaging in more speculative activities such as synergistic (at first), then less-well-planned M&A activity since there is lessened risk of doing so when the economy is moving in a positive direction. High levels of growth can mask a lot of missteps. But, at some point, these excesses grow too large and overwhelm the system, meaning fragility has expanded to the point where a there are much smaller buffers to defend against smaller and smaller shocks. A tipping point of stress occurs which snowballs in a negative direction, with credit contraction, job losses and slowing growth to the point of recession. This has been the pattern for centuries.
We hate the term ‘things are different now,’ and they aren’t. But there are structural changes that have caused these cycles to evolve in both length and depth. Before the World War II era, business cycles tended to be much shorter, often lasting only a few years, and the peaks/troughs were more severe. This makes sense considering the greater proportion of goods manufacturing in the economy and far less precise tools in terms of monitoring and controlling goods inventories. The economy in general was much more difficult to measure in real-time terms. Following WWII, the domestic economy began a shift, which lengthened cycles dramatically (the average business cycle since that time has been six years). Not only have ‘services’ taken over as the primary economic driver over manufacturing, but the speed and precision at which business can react to conditions has also improved. Central banks also have more precise, granular and timely data at their disposal to theoretically make better real-time policy decisions.
These combined trends have caused business cycles to become longer and smoother and recessions less severe. This has several obvious benefits from a societal standpoint, including less severe and pronounced spikes of joblessness that have accompanied more severe manufacturing-based recessions and depressions, such as the Great Depression (in fact, the term ‘depression’ has been removed from the modern vernacular almost entirely, although the Great Recession has come as close as anything in recent generations). For political reasons and broader aims, government policy has always favored periods of prosperity for as long as possible, preferring to avoid downturns altogether (although that’s economically unhealthy, let alone impossible). The argument against that thinking from a capitalistic standpoint is that if firms are either not penalized for bad decisions by the possibility of failure/bankruptcy or become ‘too big to fail,’ then the resulting asymmetrical payoff profile (all potential reward, no risk) incents businesses for taking excessive risks, which could cause eventual more catastrophic imbalances, but this is a discussion for another day.
Long-story short, albeit unpleasant, recessions are healthy parts of a capitalistic business cycle. So we are bound to have one again, and another in the next cycle after that, ad infinitum. Because of the flattening of these cycles recently coupled with other economic and demographic changes we’ve noted before, it has become a bit more difficult to easily model the severity of soft patches due to the lower overall levels of growth. Are we on the precipice of one now? It doesn’t appear so, based on the opinions of a variety of well-regarded economists. We’re in the 7th year of this current expansion, which would rank as the 5th longest of the almost three dozen expansions since 1900. However, levels of various indicators in the economy remain mixed. While auto/truck sales have been extremely solid, housing metrics have lagged. Inflation remains low, as do wage growth levels, although there is mixed evidence of some movement in the latter, but nothing on the extreme side to show any type of ‘overheating’ typically seen in the latter stages of expansions. Earnings growth has been sub-par to say the least over the past year, but much of this has been due to weakness in the energy patch and mining/materials. On the other hand, unemployment has declined dramatically to near ‘full’ levels and might be hard to improve on radically from this point—although it still could move lower.
Another factor is sentiment. Like with many stock bull markets, economic peaks often coincide with general business and consumer optimism. In fact, high levels of overconfidence likely contribute to the less-risk-aware decision-making that occurs at these periods, which helps exacerbate later trouble. But currently, the echoes of the Great Recession appear to continue to weigh on sentiment and focus continues on the negative—whether it be a Greek debt default, economic woes in China, a strong dollar, lack of inflation, oil price volatility (of the usually-good type), demographic changes, etc. While this is characteristic of financial media coverage, finding references to anything going ‘right’ has been very difficult.
In short, timing cycles and predicting recessions has been a futile exercise. But, current indicators and a few of the better warning signs (like a negatively-sloped yield curve) don’t appear to show red flags yet but will become a greater focus in quarters/years to come as the Fed policy shifts to tightening as is currently assumed.
Read our Weekly Review for November 30, 2015.
Read the previous Question of the Week for November 9, 2015.