The economy is cyclical. There have been 14 recessions starting with the great depression of 1929 according to National Bureau of Economic Research, the official arbiter of such statistics in the United States. The analysis of cycle is at the heart of investment decision making and capital allocation. The widespread application of unconventional monetary policies to combat the effect of the great recession of 2008 has placed this view under attack.
In the cover story titled “The Bull Market Has No Expiration Date”, J.P. Morgan US Equity Strategist Dubravko Lakos-Bujas was quoted, “We are all used to using the word ‘cycle’; we’re all used to looking at historical charts and graphs and equations and relationships. The reality is that maybe the word ‘cycle’ is no longer even relevant, given that we have so much unconventional central-bank involvement.” The CEO of J.P. Morgan Jamie Dimon echoed the same sentiment on its first quarter earnings conference call, “There’s no law that says it has to stop,” referring to the current economic expansion.
Historically, proximate causes of recessions vary, including tight monetary policy, bursting asset bubble, high inflation and excessive leverage. The actual causes had always been a mismatch and subsequent adjustment between aggregate demand and supply. Although economic cycles and corporate earnings cycles can not be matched precisely, they are closely related and are caused by the same underlying economic force. Capitals are always attracted to the highest return. Yet too much capital chasing the same opportunity always leads to lower return. The economic cycle is thus rooted in the human tendency to respond to incentive. This may not have the formulaic conciseness of Newton’s Law of gravity, economic cycles have been with us for as long as the economy existed and are likely as unalterable as gravity itself.
At a negative 0.75%, Swiss National Bank sets the lowest interest rate in the world. In a recent speech in Washington DC, SNB chairman Thomas Jordan remarked, “We always stress the point that we have room to lower interest rates still further.” Since the great recession of 2008, the economic landscape could be characterized as a deficit of demand. Thus, it fell to the central bankers around the world to enhance it. First it was the conventional policy of lowering interest rate. Next came the unconventional quantitative easing. Finally, interest rate was lowered to hitherto unthinkable negative territory. Yet in December of 2018, demand was falling precipitously. Both credit and equity market were in convulsion.
One trillion dollars’ worth of liquidity was then quickly injected into the global economy including $800 million by the People’s Bank of China equating to 5% of its GDP in a single month of February. As the liquidity spread, the economy stabilized. The fire that came swiftly was swiftly extinguished. At the beginning of March, Atlanta Fed’ GDPNow Model pegged first quarter GDP growth at less than 0.5%. It now has risen to a very solid 2.8%. With magic like this, why would anyone still worry about economic cycle?
Despite strong first quarter GDP, yield curve remains flat and inverted between 1- and 5-year notes. Even with much lower interest rate compared to just three months ago, auto and home sales have shown no sign of recovery. The persistent determination of central bankers may indeed forestall the necessary adjustment between supply and demand for the foreseeable future, corporate earnings which must account for both cost and revenue are not faring so well. During the long and slow expansion over the past ten years, earnings growth nearly always exceeded revenue growth as companies held cost down and used up existing capacity. The first quarter of 2019 is unfolding very differently. According to data from Factset, aggregate earning for the S&P 500 companies is estimated to contract 3.8% while revenue increases by 5%.
Stocks have enjoyed a record breaking first quarter. Signs of a maturing economy and aging bull market are also everywhere. Individual investors are gaining confidence; corporate margins are under attack; most cyclical sectors in the economy are stalling. Despite the length of the bull market, the cyclical progression has largely adhered to traditional metrics. It is now time for investors to reduce risk and play defense.
Etched high upon the monuments to hubris are phrases like “permanent plateau” uttered in 1929 and “death of equity” declared in 1979, “the irrelevance of cycle” seems to make a viable candidate. Suffice to say, the cycle lives and will outlive us all.