Equity bull markets rarely end without a recession. Other catalysts are often a factor, but the business cycle is the one constant in the evolution of bull and bear markets. It is therefore necessary to track key attributes of the business cycle to gauge how the expansion is evolving and calculate the risks of a recession.
We characterize the US business cycle as currently in the mid-to-late cycle stage. GDP growth is likely to exceed 3% through year-end, well above potential growth estimated at 1.6%. The labor market is tight, though wage growth is below 3% and inflation is right near the Fed’s 2% target. Thus, the economy is warm but not hot, though clearly on a path to overheating. Meanwhile, financial conditions remain accommodative: the federal funds rate is still below neutral, credit conditions are loose, and a flattening yield curve is not yet worrying. Overall, it’s hard to see the expansion ending any time soon. But monetary policy could be restrictive by this time next year and fiscal policy will be contractionary in 2020 based on current law, raising risks to the cycle two years out.
The US economy continues to reaccelerate, with UBS estimating that 2Q GDP growth is now tracking at 3.8%. Manufacturing surveys remain at elevated levels, while consumer spending and business investment both continue to pick up. The unemployment rate fell to 3.8% in May, but wage growth remains in a narrow range around 2.7%. Inflation continues to rise slowly toward the 2% target for core personal consumption expenditures (PCE). The Fed hiked rates 25 basis points (bps) in June, as expected, and is now anticipating four rate hikes this year, up from three. But interest rates and credit spreads are largely unchanged over the past month, keeping financial conditions generally loose. Consequently, we didn’t change the score for any of the Bull Market Monitor indicators this month.
What are we watching?
With US growth looking very solid, we’re watching for signs that the economy is overheating and for consequences of escalating trade tensions. Inflation pressures are building since there is little spare capacity in the economy. The risk is that inflation overshoots 2% and rises to 2.5%, forcing the Fed to raise rates faster than expected. The USD 50bn in tariffs on imports from China should reduce growth by about 0.1% and lift inflation by even less than that, but those impacts will be larger if tariffs are imposed on an additional USD 200bn or more of imports.
What are the investment implications?
The reflationary growth environment that we expect for the rest of this year supports our tactical global equity overweight, as well as our preference for value over growth among US large-cap equities. The acceleration in US growth hasn’t been matched in Europe and emerging markets, which has led to further US dollar strength. This divergence in cycles, and the risk that this continues, contributed to our decision to close our tactical overweight to emerging market (EM) equities and reduce the overweight to EM USD-based sovereign bonds.
Key cycle indicators
The cycle indicators are evaluated to gauge whether the economy is overheating and if financial conditions are becoming restrictive for growth. These determine our overall assessment of where we are in the cycle.
Overall: mid-to-late cycle
Growth (relative to potential)
Inflation (relative to 2%)