Is the US Expansion Nearing Its Peak?
- By Dominique Dwor-Frecaut
- 4 min read
Summary
- Current economic and market data suggests the US economy could be in the late stage of its post-pandemic expansion.
- A short expansion could reflect overstimulation of the economy that has created risks of a hard landing and generated inflation undermining household incomes.
- An ongoing wave of technological innovation is unlikely to lift growth due to structural demand weaknesses.
Market Implications
- Medium term: curve to flatten further; equities could continue to perform well if the slowdown is mild.
What Goes Up Must Come Down
The expression ‘business cycle’ conjures the image of a nicely behaved cyclic function. The reality is much messier: other than rising and falling, growth follows no obvious pattern (Chart 1). Expansions are highly variable in duration and end for various reasons – often but not always due to monetary and fiscal tightening and sometimes unpredictable shocks such as the pandemic. Occasionally, policy tightening interacts with underlying fragility to trigger the recession, e.g., the 2004-06 Fed tightening and credit bubble.
The US Economy Could Be End-Cycle
While expansions are of highly variable shapes and durations, a few recurrent differences between the start and end exist. I have used the NBER chronology to break the past 50 years of expansions into four equal phases, and I compare key economic variables in the first and last parts of the expansion (I have omitted the 1980-81 expansion because it lasted only eight months). Here are some stylized facts:
- Demand slows as it nears the peak. Consumption and investment growth tends to be slower in the late than early part of the expansion. A key exception is the 2009-20 expansion, which reflects it being cut short by an exogenous shock rather than endogenous dynamics.
- Economic slack (measured by the current account balance, industrial capacity utilization and unemployment) is smaller and inflation higher in the late than early part of the expansion. The exception is the 1991/01 expansion when inflation was higher in the early part, but this reflected the structural disinflation of the 1990s.
- Household and nonfinancial business liabilities grow faster in the late than early phase of the cycle, which could reflect that borrower and lender optimism grows with the expansion. Money growth, by contrast, is slower in the late part of the expansion which, consistent with more borrowing, could reflect lower private sector savings (broad money M2 is roughly equal to bank deposits and MMF).
How does the current expansion fit these patterns? A comparison of the last macro data available, March-May 2021, with Q3 2020 suggests the economy could be near peak: demand is growing much more slowly, slack has fallen and inflation increased. Simultaneously, money growth has slowed, while household and business borrowing has increased.
At 6%, unemployment would be high for the end of an expansion. But considering the many bottlenecks involved in reopening the economy, unemployment might not fall much lower this cycle. Also, 6% unemployment would be comparable to the unemployment prevailing at the end of the 1975/80 expansion (5.9%).
Will Expansion End in 2022?
The above comparison suggests the economy could be closer to the end of the expansion than the currently high unemployment suggests. This would be consistent with tighter monetary and fiscal policies next year, with fiscal policy much tighter. Essentially, by overstimulating the economy, fiscal and monetary policy could have shortened the expansion by creating risks of a hard landing. And further policy easing to extend the expansion seems unlikely given the currently high inflation prints.
Market Consequences
The curve could flatten further as it seems steep compared with previous late expansions. Also, even though the economy is likely close to peak, the Fed is preparing to normalize policy. Finally, inflation will likely surprise on the downside once the holiday-related surge in demand for transportation goods and services, hotels, and restaurants is behind us.
Equities could continue to perform past the expansion peak if the slowdown is mild. With limited headline macro risks, equities could remain in TINA-land, supported by low bond yields, a Fed with a bark likely worse than its bite, and disinflation.
However, the unprecedented intensity of the 2020 monetary policy easing, following a decade of ultra-loose monetary policy, is bound to have generated financial imbalances. High corporate and government leverage comes to mind, but other imbalances may exist – as, for instance, the default of Archegos Capital Management suggests. Should the slowdown expose underlying corporate weaknesses, and investors start worrying more about capital losses than returns equities would be hit hard since current prices reflect more high multiples than strong fundamentals.