Dog Days of the U.S. Expansion

Global CIO Commentary by Scott Minerd

Ever since I was a child, the Kentucky Derby has always been for me a symbol of the changing of seasons—winter is over, spring is in air, and, most importantly, summer is right around the corner. Back in 2009, at the time of the annual “Run for the Roses,” I wrote a memo to our clients using this analogy to explain where we are in the business cycle. The ravages of winter were over, I wrote, and we were headed for the warmth of summer with bright prospects for investors. Six years later, the summer sun continues to shine on credit and equities, but the question I am consistently asked—especially during times of heightened volatility, like this past week—is how much longer can it last?

I answered this question recently at the Milken Institute Global Conference. If the economic “summer solstice” was mid-2009, then today we are somewhere in “late-August.” The expansion is now over 70 months old and is entering its mature phase, having already exceeded the average length of prior cycles of 57 months. However, “late-August” means there still is time left in summer and room left in this expansion. The past three cycles have also been longer than normal, averaging 94 months. Additionally, growth has been abnormally sluggish in this recovery (which, as I’ve written, is a byproduct of macroprudential policy). Slower growth means the current expansion may have more headroom than is typically the case at this point in the cycle.

What can investors expect as summer draws to a close? Our view of the future is that the Federal Reserve will likely begin interest rate “liftoff” in September of this year, and will continue to tighten at a steady pace until it nears the terminal rate (or peak Fed funds rate) in the cycle. This will likely occur toward the end of 2017 or early 2018 in the range of 2.5 to 3 percent. Recent experience suggests that a recession typically occurs about a year after we reach the terminal rate. If this tightening cycle plays out as we suspect, the U.S, economy will face its next recession in late 2018 or early 2019.

While the best of the post-crisis returns are now behind us, the good news is that historically, until central banks remove the proverbial punch bowl of accommodative monetary policy, the party can continue for investors. As a matter of fact, our research shows that both the lead up to, and the first year after, the Federal Reserve begins a tightening cycle have been positive for both credit and equities. Historically, U.S. equities have returned close to 4.5 percent in the 12 months after a Fed tightening cycle begins, based on an average of the last 13 cycles, while bank loans returned an average 5.8 percent, high-yield bonds returned 3.9 percent, and investment-grade bonds returned 3.3 percent in the three cycles since 1994 (when the data for fixed-income asset classes became available). The 12 months prior to a Fed hike have proven even better for investors, with equities returning an average 16.4 percent, high-yield bonds returning 8 percent, and investment-grade bonds returning 9.9 percent.

I don’t want to sound overly bullish, however. My view is that it is prudent to start to recognize what stage of summer we are in, and to understand that long-term investors need to start planning for winter, even if winter is a couple of years away. This doesn’t mean there aren’t opportunities between here and there—the punch bowl is out, the party is still going on, and we should drink long and deep for as long as we can. The European Central Bank has told us that it won’t halt its quantitative easing program until September 2016 at the earliest, which is another positive for credit and equities, even as the Fed raises rates in the United States.

So let’s enjoy the end of this long summer party. There are still some golden, halcyon summer days ahead and it would be premature to put on our winter clothes just yet. Indeed, on the extreme end, the expansionary cycle of the early 1990s lasted over 118 months. However, when all is said and done, the easy money in this expansion has already been made and investors should be thinking about the winter to come.

Economic Data Releases

Few Surprises in April Payrolls

• Nonfarm payrolls slightly missed expectations in April, rising 223,000. The prior two months were revised down by a combined 39,000.
• The unemployment rate ticked down to a new post-recession low in April of 5.4 percent, even as the participation rate rose to 62.8 percent.
• Average hourly earnings rose just 0.1 percent in April, putting the yearly growth rate at 2.2 percent. Average weekly hours were unchanged at 34.5.
• Initial jobless claims remained at subdued levels for the week ending May 2, rising slightly to 265,000.
• The ISM non-manufacturing index beat expectations in April, rising to 57.8, the highest since November.
• Factory orders rebounded in March, rising 2.1 percent after a 0.1 decline in February.
• Productivity fell in the first quarter, down 1.9 percent after a 2.1 percent drop the previous quarter.
• The trade deficit widened more than expected in March, growing to a six-year high of -$51.4 billion.

European Data Falters, China Slowdown Continues

• Euro zone retail sales declined 0.8 percent in March, the first decrease since last September.
• The euro zone manufacturing PMI was mostly unchanged in the final April reading, inching up to 52.0 from the earlier estimate of 51.9.
• The euro zone services PMI was revised up in the final reading for April, but still showed a small decline from March at 54.1.
• After falling the past two months, German factory orders rose 0.9 percent in March, a smaller rebound than forecast.
• German industrial production disappointed in March, falling 0.5 percent after no gain in February.
• Exports out of Germany rose for a second consecutive month in March, increasing 1.2 percent.
• French industrial production missed estimates in March, falling 0.3 percent, the worst month since October.
• Italy’s manufacturing PMI rose for a fourth consecutive month in April to a one-year high of 53.8.
• The U.K. services PMI rose to an eight-month high in April at 59.5.
• China’s HSBC manufacturing PMI fell in the final April reading, reaching a one-year low of 48.9.
• China’s HSBC services PMI rose for a third straight month in April, rising to 52.9.
• Chinese exports stayed in contraction on a year-over-year basis in April, falling 6.4 percent. Imports also shrank for a sixth straight month.

VIDEOS AND PODCASTS

 

2022’s Upside: The Fed Has Put the Income Back in Fixed Income

Anne Walsh, Chief Investment Officer for Fixed Income at Guggenheim Investments, joined Asset TV to discuss macroeconomic conditions, risk, and relative value in the bond market.

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2022’s Upside: The Fed Has Put the Income Back in Fixed Income

 

Macro Markets Podcast Episode 26: Mortgage-Backed Securities, Structured Credit, Market Liquidity

Karthik Narayanan, Head of Securitized for Guggenheim Investments, discusses value in the residential mortgage-backed securities market and other ABS sectors. Anne Walsh, Chief Investment Officer for Fixed Income, answers a listener question on liquidity. Jerry Cai, an economist in our Macroeconomic and Investment Research Group, brings the latest on the labor picture and an update on China.

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Macro Markets Podcast: Episode #26