investment viewpoints
Is the economy in a late-cycle period?
Today’s unconventional economic context continues to confound investors. In this weekly installment of Simply put, we look to history as a guide for the markers defining a late cycle.
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August marks a turning point
The equity market rally from November 2022 to the end of July 2023 created a trend that CTAs would have been hard-pressed to miss. A genuine ‘risk on’ signal gradually emerged, prompting a significant proportion of systematic investors (in particular) to overweight equities and credit, and underweight bonds. In terms of risk premia, a significant proportion of these investors added equity and credit premiums but reduced duration risk.
While this trend was fairly well captured by the funds that follow them, a considerable part of the market remained on the sidelines, missing out on a substantial portion of this rally for a variety of reasons, both micro and macro. August marked a turning point for these trends, and CTAs certainly felt it.
This change in trend coincides with a change in environment in our macro indicators about which we have already communicated extensively: suddenly, marginally more positive growth signals have appeared against a backdrop of renewed inflationary pressure. It's enough to make scenario-driven investors wonder whether it’s the end of disinflation and economic slowdown – or a soft-landing scenario. Probably not. More likely, we're facing a fairly classic end-of-cycle period, or a temporary turn in the road towards greater inflation control.
So what happens during such late-cycle periods? Here's a quick recap of previous end of cycles.
The last three late cycles
Excluding 2020, when the recession was caused by exogenous factors, there have been three endogenous recessions in the last 30 years: the 1990 recession, the 2000 recession and the 2008 recession. The European sovereign debt crisis of 2011 and the pronounced Chinese slowdown of 2015 are deliberately excluded here, as these two shocks were more domestic than global. In the other three cases, global GDP as a whole slowed (if not outright declined) in its progression.
What happened to markets in a late-cycle period or the twelve months preceding these recessions? Figure 1 analyses trends in six markets to provide a global perspective of interest to asset allocators such as ourselves: developed and emerging equities, government and high-yield bonds, commodities and the dollar (presented in effective exchange rates). While we could spend hours detailing the specific features of each of these crises, we find it wiser to focus on their three similarities:
- During the last three crises, the bond world as a whole suffered, whether in terms of duration or credit spreads. In the three to six months preceding a recession, fixed-income performance was generally negative
- While developed equities showed no particular trend, emerging equities were clearly outperforming. Emerging assets as a whole tended to outperform
- Commodities tended to outperform, while the dollar fell. These stylised facts characterised the year that preceded the last three recessions, without any notable exceptions
In light of these similarities, today’s context shows:
- Bonds have clearly underperformed in recent months
- Emerging equities have not outperformed developed equities
- Commodities are up, but the dollar is not falling
Therefore, the current market situation ticks only a few of the late-cycle boxes seen previously. In comparison, the period preceding the 2000 recession seems most similar to what has emerged this summer. Emerging assets have not yet outperformed (and were one of our notable recent overweights), and the dollar has not yet retreated: it’s probably worth keeping an eye on these two trends.
Figure 1. Trends in various markets 12 months before a recession
Source: Bloomberg, LOIM.
The late-cycle macro
If some similarities arise between the current situation and the last three late-cycle periods, can the same be said about macro trends? What happens during such periods in our nowcasting indicators?
Figure 2 shows the average level of our growth signal decomposition for the United States during these late cycles and compares it with current levels. Overall, there are a number of striking parallels:
- Consumption, real estate and production expectations are below 50%, reflecting the weakness of an economy undergoing a downturn
- Two differences persist: employment remains strong, and the latest employment report did not change this fact. Secondly, in terms of investment, if our indicator is below 50%, it is only marginally so, whereas 3 to 6 months before recessions this component tends to give off stronger negative signals
Whichever way you look at it – financial markets or economic data – there are striking similarities with these previous end of cycles. This has probably been forgotten since 2008, in the absence of a severe slowdown in the economic cycle since then, but these end-of-cycle situations are eminently frustrating and a source of doubt for investors: do conditions presage a recession or merely a simple slowdown? These questions are not new, and despite today’s extraordinary situation, history must continue to serve as a guide. Here, many indications suggest we are in a late cycle.
Figure 2. Decomposition of the US growth nowcast prior to a recession
Source: Bloomberg, LOIM
| Simply put, the current period feels like the end of a cycle. Market and economic data seem to indicate as much. |
Nowcasting corner
This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.
Our nowcasting indicators currently point to:
- Our growth indicator rose over the week, notably under the influence of better-than-expected economic data in the US
- Similarly to growth, our inflation indicators also rose marginally again this week. Once again, this indicator was driven by the US
- Monetary policy indicators are stable, still pointing to a moderation in the tone of the major central banks
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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