January 2019 Letter
“It’s tough to make predictions, especially about the future.”
We’re not sure if Yogi Berra had the stock market in mind when he said this line many years ago, but it could easily apply today. As we begin 2019, the stock market seems to be at a bit of a crossroad. In 2018, despite record corporate profits, the S&P 500 suffered two significant corrections, one to start the year and one late in the year. Stocks corrected 10% in early February, and then more than fully recovered through the summer given stronger than expected economic growth. The second downturn was much sharper, approaching 20%, and seemed to suggest a growing doubt about the sustainability of an economic expansion looking to enter its tenth year. In this letter, we’ll explain the basic elements of the business cycle and take a quick look back at how the current business cycle has evolved. More importantly, though, we’ll explain how some of today’s major issues affect our thoughts on where the business cycle may be headed.
The Four Phases of the Business Cycle
The business cycle is the natural rise and fall of economic growth that occurs over time. Economists analyze these cycles to guide current policy. Investors can also use them to make better financial decisions.
Each business cycle has four distinct phases. They are slowdown, recovery, expansion, and peak. They don’t occur at regular intervals, but do have recognizable indicators. The average business cycle in the U.S. is about six years. We’ve had approximately 11 business cycles since 1945.
The first phase is slowdown. It starts near the peak and ends around the trough. Economic growth weakens and GDP growth falls below potential. When it turns negative, that is what economists call a recession. Corporate profits are slowing and mass layoffs make headline news. Stocks often enter a bear market as investors sell.
The recovery, or trough, is the second phase. It's the turning point at which a recession ends and output starts increasing again. Monetary policy is easy, interest rates are falling, inventories are low, consumer demand begins to turn, and businesses start to hire new workers.
Expansion is between the trough and the peak. That's when the economy is really growing. Corporate profits are rising while unemployment is falling. Confidence is high and the stock market begins a bull market. A well-managed economy can remain in the expansion phase for many years. That's called a Goldilocks economy.
The peak is the final phase as the economy overheats. It marks the turning point in the business cycle at which output stops increasing. Inflation heats up and asset bubbles are often created as monetary policy is tightening. Investors are in a state of "irrational exuberance."
The current cycle was born out of the Great Recession in mid-2009. It now has the distinction of being the third longest expansion on record, surpassed only by the “60’s Boom” of 1961-1969 and the “Tech Boom” of 1991-2001, and in another year or so can claim to be the longest. But this expansion also has another, not so positive, distinction. It has been the least robust. The nearby chart shows how the current expansion has lagged other cycles in total growth since the prior peak. The light blue line representing the current expansion also shows how this time around we dug a bigger ditch in the downturn and it took considerably longer just to reclaim the prior cycle peak, approximately three years. The ‘60’s and ‘90’s, while similar in length, enjoyed a much more robust total expansion. Looked at another way, in 2017 total GDP was only about 20% larger than it was in 2008, while the “’60’s boom” ended with total GDP around 50% higher than the previous peak.
There are many theories and arguments about why this cycle has lagged, but in general, its relative underperformance reflects the nature of the prior downturn. The “Great Recession” was a global case of excess debt. Earlier economic downturns were characterized by overheated business conditions that resulted in inflationary pressures and the misallocation of resources. Interest rates would rise, choking off investment and allowing prices and resources to reset, albeit with a short-term decline in economic growth. In 2008, the world was awash in debt, from U.S. households to small European nations. This required a re-working of the global financial system and clearing of debt, a more complicated process than clearing excess inventories. It also required global central banks to put in place extraordinary easing policies, some of which are still in place. U.S. policy makers were generally ahead of the rest of the world in re-capitalizing and de-risking U.S. financial institutions, but many other countries took several years longer and some are still coping with debt issues ten years on. As a result, it’s only been in the past year or two that much of the world has seen economic growth at the same time.
The U.S. Federal Reserve (Fed) controls short-term interest rates by setting the Federal Funds Rate (FFR). In late 2008, Chairman Ben Bernanke took the unprecedented step of setting the rate at zero. Additionally, owing to the size of the ditch we were in, the Fed decided to influence long-term interest rates by buying up a variety of longer-term securities, hoping to drive bond prices higher and bond yields lower. Chairwoman Janet Yellen continued these policies all the way through 2015. The U.S. economy expanded at a modest rate, inflation stayed below the Fed’s two percent target, unemployment fell, and the stock market grinded higher. By 2016, the unemployment rate fell below five percent and the Fed began making plans to take the punch bowl away. For the past two years, the Fed, now under the leadership of Jerome Powell, has steadily raised the FFR and discontinued bond purchases. The economy (and stock market) must now prepare for life without easy money.
Also in 2016, the nation took a turn politically. As part of a broad economic agenda that included lower taxes and fewer regulations, the new administration sought to re-negotiate trade deals with many of our largest trade partners. While markets cheered pro-growth initiatives, including lower corporate taxes and less red tape, wariness began to creep into investors’ minds about the aggressiveness of upending existing trade agreements and the possible disruption to economic growth. U.S. tariff rates on imports rank among the lowest in the world and had trended lower for the past fifty years. The new administration, however, looked at tariffs as leverage to help correct trade imbalances and possibly incentivize manufacturers to move production back onshore.
The administration took aim, specifically, at China, our trading partner with the largest trade deficit, accounting for nearly half of our entire trade deficit. Trade issues with China extend beyond the simple math of subtracting exports from imports. Other issues include intellectual property theft, unimpeded market access, and cybersecurity. In a series of moves during 2018, the President proposed a 10% tariff on roughly half of our Chinese imports and threatened to go to 25% on all Chinese imports if talks broke down. U.S. companies and analysts all began trying to assess how these higher fees would filter through the economy, most likely resulting in some combination of pinched profit margins and higher prices for the consumer. Stock markets now have to contend with two concerns, higher interest rates and tariffs.
The Road Ahead
As 2018 drew to a close, Fed Chair Powell struggled to reassure markets that he believed the Fed was closer to a neutral posture than had been previously believed. In short, the hope is the Fed will take a more measured approach to raising rates in 2019 and is not on some predetermined course. This is important because, historically, the Fed has tightened policy right into a recession. Also late in the year was news of an agreement between the U.S. and China on a temporary truce in trade tensions. The agreement is scheduled to last through February. A breakdown in talks would likely have a negative effect on global markets.
We’ve included our current view of the business cycle by adding the flags of The European Union, China, and the United States. U.S. GDP is forecast to grow 2%-3% and S&P 500 profits are expected to increase modestly in 2019. Right now, we are in the late stages of the business cycle, warranting prudent asset allocation rebalancing: gradually increasing cash positions, maintaining higher quality and shorter maturity fixed income holdings, and broad equity diversification emphasizing companies with durable competitive advantages and the ability to self-finance growth.