No two economic cycles are the same, but as the American writer Mark Twain so eloquently put it, “history does not repeat itself, but it often rhymes”. However, this cycle turns out to be particularly different, which makes it even more difficult to draw parallels with the past.
Depending on the indicators you are looking at, the US economy could be classified into one of four phases of the business cycle. They are boom, bust, bust and recovery.
If we use the classic definition of a recession – two consecutive quarters of negative real GDP growth – the United States is one of them. Recessions, however, are usually accompanied by a significant increase in the unemployment rate, which has not happened.
Instead, the unemployment rate is at its lowest in decades. Indeed, the strength of the labor market testifies to an economy in a phase of expansion, although it is now clearly pushing back its limits of capacity.
However, other economic indicators, such as business surveys (deteriorating) and the rate of change of inflation (still accelerating), suggest an economy already experiencing this particularly difficult type of slowdown, stagflation. Admittedly, the sharp devaluation of US equities observed this year is part of stagflation.
In short, this business cycle cannot be easily categorized.
Unique circumstances have created a two-speed economy
As the rapid pace of rate hikes by the Federal Reserve (Fed) continues to take effect, we expect economic indicators to become less contradictory. This should happen next year when we expect the US economy to be in recession (see: Why recession threatens the developed world).
Since the post-war period, each time there have been two consecutive quarters of negative real GDP growth, the recession has been confirmed by the NBER (National Bureau of Economic Research). The NBER is the official authority for dating US recessions based on tracking a variety of macroeconomic indicators.
So far they have not announced a recession.
The weakness in second-quarter GDP was also skewed by a significant decline in inventories after strong inventory build-up in previous quarters. It therefore seems premature to call the end of the cycle on the basis of recent disappointing GDP publications.
On the other hand, the Schroders output gap model, which measures the amount of spare capacity in the economy, suggests that the US business cycle remains in an expansionary phase (see chart 2, below). Indeed, the output gap is positive and growing.
The output gap is the difference between an economy’s actual output and its potential output, a positive output gap suggests the economy is running out of spare capacity, which adds to inflationary pressures.
Normally, monetary policy would be tightened at this point to bring real output back to potential (the maximum level of output an economy can produce without generating inflation). The Fed is currently trying to design this.
As activity slows, the positive spread begins to narrow and the economy enters a slowing phase – although that is not happening yet after a meteoric pace of rising interest rates.
Schroders output gap business cycle pattern and phases
Expansion – the output gap is positive and rising
To slow down – the output gap is positive and fall
Recession – the output gap is negative and fall
Recovery – the output gap is negative and rising
Instead, a currently positive and growing output gap reflects the strength of the labor market, as evidenced by the “unemployment gap” (Chart 3). The unemployment gap is one of the main inputs to the output gap model and tells us if there are fewer unemployed people compared to trend levels.
Monetary policy makers pass judgment on what the NAIRU (rate of unemployment without accelerated inflation) is, which is the lowest level of unemployment that can be reached before inflation begins to rise in the economy .
It will therefore take a significant increase in the unemployment rate before the positive and growing output gap begins to close.
U.S. economy and markets show more end-of-cycle traits
While we expect our output gap model to slow in early 2023, we recognize that other sectors of the US economy are already exhibiting late-cycle characteristics. Growth momentum peaked and business surveys slowed while inflation picked up.
Even particularly poor market performance is typical of a stagflationary environment. The performance of the S&P 500 year-to-date (YTD) is more consistent with past downturns as defined by our output gap model (see chart 4, below).
Stocks typically suffer during downturns as corporate profitability is hit by weaker growth and rising costs due to rising wages and interest rates.
But the scale of the equity losses this time around have been larger compared to past downturns. Despite strong corporate earnings, valuations have derailed significantly.
Indeed, high levels of inflation have led to more aggressive expectations of Fed policy tightening.
This cycle turns out to be quite different
We find ourselves in rather unusual circumstances in that the contraction in economic activity this year came after a very strong recovery in growth following the Covid-19 lockdowns. Thus, the macro data returned to more normal levels.
At the same time, US inflation at 8.5% is generally elevated relative to past cycles. This has led to comparisons with the stagflationary period of the 1970s, when inflation at the time reached record highs brought on by an oil price shock.
Unlike the 1970s, the imbalance between supply and demand for goods, resulting from the Covid-19 pandemic, is at the root of inflation in this cycle (see: Three reasons why inflation is not going not go away any time soon). This situation has been further exacerbated by the war between Ukraine and Russia and the impact on supply chains resulting from China’s zero Covid policy.
It is therefore not easy to draw parallels with the 1970s, in particular given the strength of the labor market (see graph 5, below).
Tension in the labor market has also been fueled by factors resulting from the pandemic. In particular, the decline in the number of workers participating in the labor force.
First, more people in older cohorts have decided to retire early due to health issues. Second, some workers have chosen to leave the labor market due to a reassessment of priorities such as care for loved ones. Third, the long Covid has hit the workforce and, according to the Brookings Institute, accounts for 15% of the 10.6 million unfilled jobs in the US (see here).
Some of these factors may diminish over time as higher wages incentivize workers to re-enter the labor market. But more importantly, the Fed’s tightening of monetary policy to bring inflation back to its target should result in a deeper slowdown in growth (see: Forget about soft landings – how much recession does it take to rein in inflation?) and a rise in the unemployment rate. This would lead to a return to a more normal economic cycle.
Some semblance of normality back, but not quite yet
We expect a semblance of a normal cycle return over the next few quarters as the US economy enters a recession. Not only would GDP growth be likely to contract, but the recovery in the unemployment rate would first lead to a narrowing of the output gap and then turn negative. Inflation should also have come down from elevated levels.
For investors, this would mean a return to more familiar territory where equities offer attractive valuation opportunities in a recession. At the same time, despite dismal corporate results, US equities have generally been buoyed by market revaluation (Moving from recession to recovery: How can investors position themselves?).
This is happening through the central bank lowering interest rates in response to the deteriorating growth and inflation landscape.
We saw with this summer’s rally how investors (prematurely) anticipated a “pivot” by the Fed towards a less restrictive policy, in favor of economic growth and its second mandate of maximum employment. This led to a powerful revaluation, which reversed sharply as Fed Chairman Jerome Powell dashed hopes for easier policy in the near term.
He warned that the central bank would “push through” on raising interest rates.
We expect, however, that there will be room for a Fed pivot towards the end of next year, as policy should be eased to counter the impact of a recession.