Spotting the end of the economic cycle

The biggest surprise in 2018 has been that the U.S. economic cycle has proved to be more resilient and more extended than we expected. President Trump’s tax cuts boosted consumer sentiment and kept consumption buoyant, although the response of business capital expenditure to the improved investment incentives delivered by the tax reform remains underwhelming.

By contrast, the rest of the world failed to match expectations. In Europe, explanations for lacklustre growth have evolved over the course of the year. It increasingly looks as though falling external demand has been the root cause, not least from China as the effect of the earlier stimulus wears off.

To us, it looks a lot like the end of the cycle. The U.S. has been supported for some time by easy financial conditions and, more recently, fiscal tailwinds. But it feels like a lot of these conditions are about to turn. There is still optimism priced into stock markets, although the dislocation over October and November 2018 tempered that somewhat.

If this is indeed the end of the cycle, it’s no carbon copy of previous episodes. Typically, we would expect inflationary pressures to emerge in response to tightening labour markets and capacity constraints. The U.S. Federal Reserve would tighten monetary policy well into restrictive territory to prevent the de-anchoring of inflation expectations. Yet, despite above-trend growth, inflation has not accelerated meaningfully. Consequently, the Fed hasn’t yet needed to tighten interest rates, even to its own estimate of the ’neutral’ level.

Possibly the cycle is ending, but more gently than in the past. One explanation is that the response of inflation to the erosion of domestic slack is lower than historically, so the authorities have not had to tighten monetary policy so aggressively. That would be good news for assets: it means valuations can correct gently without a disruptive tightening of financial conditions.

A Shortage of tools

One potential source of volatility in 2019 might be a more synchronised and deeper slowing of global growth. If this transpired, the buffers against recession could prove thinner than they have been in the past. I would stop short of predicting a crisis, but if a gentle correction becomes a hard landing, the risks are higher than they have been in more ’normal’ cycles. It isn’t clear which parts of the world still have the policy flexibility to counter a widespread deleveraging.

Although the U.S. could ease monetary policy again, it may now have limited room for a meaningful fiscal response, given the pro-cyclical nature of its latest stimulus. In addition, China’s debt levels might preclude the kind of stimulus it has provided in previous slowdowns.

The other buffer might be Europe, which - unlike the U.S. - enjoys large current account surpluses. But the political will for co-ordinated fiscal expansion is hard to envisage and the ECB enjoys limited remaining monetary policy flexibility.

Europe’s Dilemma

The Euro Area’s economic fundamentals seem reasonably robust. Labour markets are improving, employment growth has been good, and wages have finally started to increase. Borrowing conditions are still relatively relaxed in the eurozone and economy-wide leverage remains low. Capacity constraints ought to deliver further upward pressure on wages and increased capital investment. The ECB is looking to begin its policy normalisation.

But there are risks in Europe from both internal and external sources. A deepening Chinese slowdown and continued deterioration in global trade could pose a threat, given how reliant the eurozone has been on exports in recent years. The Italian dispute with the European Commission is making markets nervous, and rightly so. Brexit is another source of uncertainty.

For the UK, a lot will depend on the shape of the future trading relationship with the EU and the respective impacts on both the demand and supply sides of the economy. It is hard for UK fixed income assets to find direction until we understand the nature of the shock.

OUTLOOK FOR YIELDS

So, what does this uncertainty mean for bond yields? Given that we think we have seen the best of U.S. growth, our bias is towards lower yields over the course of 2019, although not aggressively so, if we avoid recession. Against that, the normalisation of the Fed’s balance sheet, and the evolution of monetary policy elsewhere, may exert a positive influence on term premia, which have been very compressed in all government bond markets.

Much depends on whether inflation accelerates. If the U.S. returns to a more typical relationship between capacity constraints and inflation, the Fed might have to tighten monetary policy more than expected. In that case the economic cycle could be extended still further but may eventually end more abruptly.