The U.S. economy remains a mix of mid- and late-cycle phase dynamics, with late-cycle indicators rising in recent months. The household sector accounts for nearly 70% of the U.S. economy,1 and remains a bright spot. Over the past several years, employment conditions have improved substantially, soaking up a significant amount of excess slack in the labor markets. This report will update the outlook, with a focus on the following key questions:
- How much slack remains in the labor markets?
- How quickly will wages accelerate?
- How will wage growth affect the outlook for consumer spending and the transition from the mid- to the late-cycle phase of the business cycle?
Historical cyclical roadmap for the household sector
Labor market improvement is key to the late-cycle transition
Historically, labor markets have steadily improved during the mid-cycle phase. Typically, payroll growth accelerates and unemployment falls. As the expansion matures, the pace of job gains often slows, but because much of the slack has dissipated, the labor market tightness puts upward pressure on wages. These mounting wage pressures translate into rising prices for services and, eventually, broad-based inflationary pressures. Wage increases and the inflationary pressures tend to shift the economy into the late-cycle phase by prompting more restrictive monetary policies, crimping corporate profit margins and causing a tightening of credit availability.
Peak wage and consumption activity is a late-cycle phenomenon
The late-cycle phase has traditionally not represented a steep downturn in economic activity, but rather has often coincided with continued job gains and the peak of cyclical growth in wages and consumption. Nominal wage pressures typically begin rising during the mid-cycle phase and then accelerate and peak during the late-cycle phase. These wage gains spur consumption, where the pace of spending also tends to rise through the mid cycle and then peaks in the late-cycle phase.
Late cycle often involves overheating and broad-based inflation pressures
For consumer spending, the growth in real (inflation-adjusted) wages is important because it represents the change in overall purchasing power. Real wage growth has historically been strongest in the mid-cycle phase, when wages are growing modestly and inflation is relatively muted. While nominal wage growth historically peaks in the late cycle, the acceleration in overall inflation typically moderates wage growth in real terms and begins to eat into the consumer’s purchasing power (see chart, right). The late-cycle phase can be characterized as an overheating stage of the economy, in which real consumer spending rates have on average been similar to mid-cycle rates, but they are typically boosted by a growth in consumer borrowing. After rising inflationary pressures build over the course of the late cycle, they eventually cause more restrictive monetary and credit tightening, stagnating real incomes, and falling profit margins.
What's different this time for the household sector?
Employment markets slower to heal, but now may be tighter than perceived
The slack created by the financial crisis and devastating recession left the labor markets more damaged compared to cycles during the past few decades. Nominal wage gains have remained slow to recover, in part due to the persistence of high levels of underemployment. However, with inflation remaining low, real wage growth has been on par with previous cycles. Our expectation is that the absolute level of nominal wage gains may remain low but will continue to accelerate as in prior cycles.
Additionally, aging demographics may be masking how tight labor markets are becoming. The participation rate—the ratio of the number of people who are employed or looking for work relative to the overall working-age population—has dropped sharply since 2006 and has given many investors the impression that large numbers of potential workers remain on the sidelines. However, as the population grows older, the overall participation rate should naturally decline because fewer workers tend to participate as they get nearer to retirement age. The number of discouraged workers has declined since 2012, suggesting that demographics have been the primary driver of participation-rate declines, and that the gap in the participation rate may be narrower than it appears when compared to pre-recession levels (see chart, right). Additionally, the participation rate has finally begun to recover, signaling that employment conditions are finally strong enough for workers to reenter the labor force. Our outlook is that the pace of payroll gains may slow from their 200,000 per month average pace of the past year, but positive growth will be sufficient to continue to tighten labor markets and boost wage pressures.
Consumption softer than history, but steady and sustainable
Similar to wage growth, the pace of nominal consumption has been subdued relative to past cycles. On an inflation-adjusted basis, this weakness is less pronounced, but consumption rates throughout this expansion have been soft relative to history. Our thesis is that a mixture of secular (long-term) and cyclical forces have restrained the pace of consumer spending, but that the U.S. household sector is in solid shape.
Typically, credit growth accelerates into the late-cycle phase, as household confidence grows and consumers use debt to supplement income gains. However, households levered up to such an extent prior to the financial crisis that many still need to rebuild their savings, leaving households generally less willing or able to take on additional credit. At this point, the pace of credit card and mortgage borrowing is well below previous cycles, providing less fuel for spending growth. Despite subdued credit growth, consumer spending has been relatively healthy on a real basis.
In addition to the lack of borrowing, increased savings have dampened consumer spending rates. Personal savings rates have continued to rise over the past year, an unusual pattern in a maturing expansion (see chart, right).
A number of secular factors may also continue to suppress consumption growth. For example, slower population growth, the movement of the baby boom generation toward retirement, and the general aging of the U.S. population all present fewer demographic tailwinds for U.S. consumption than in the past. Also, structural changes to the retirement system from defined benefit to defined contribution plans have largely shifted the retirement savings burden from the employer to the household. We believe these factors have resulted in a secular upshift in the savings rate. Overall, we expect a steady, moderate pace of consumption growth, but both cyclical and secular factors will continue to restrain peak consumption rates relative to past cycles.
Key conclusions for the U.S. household sector
- Despite the muted pace of growth, consumption will be strong enough to keep the U.S. expansion going.
- Wage growth may be low and job gains may slow, but wage inflation is picking up as labor-market slack is fading.
- Though the transition is unfolding at a relatively slow pace, gains in wages and jobs will keep boosting the probability of the U.S. entering the late-cycle phase.
Business cycle: macro update
United States: Recession risks remain low
Corporate earnings may surpass subdued expectations. Last year, the strong dollar, falling oil prices, and weak global demand combined to drag U.S. corporate profits down 11%.2 During Q1, U.S. earnings expectations for calendar-year 2016 dropped to just 3.5%3 amid concerns about the trajectory of the global economy. However, in recent weeks, leading indicators of global manufacturing activity have improved (see Global section), oil prices have moved higher, and the dollar has fallen (see chart, right). Muted market expectations may pave an easier path to upside earnings surprises, particularly if the global economy, oil prices, and the dollar stop providing headwinds.
Oil (and inflation) likely to rise
Inflation pressures remain mixed but are on track to rise over the next year. Continued labor-market tightening has kept nominal wage growth around 4% and should help maintain core inflation north of 2% year over year.4 While the plunge in oil has been a deflationary counterbalance, low oil futures prices are likely to lead to further declines in U.S. production, which should bring greater supply-demand balance and potentially higher prices as the year progresses. With core inflation firm, headline inflation will likely rise over the course of 2016 even if oil prices merely stop declining.5
Credit: A mix of mid- and late-cycle dynamics
The credit cycle continues to experience a mix of mid- and late-cycle dynamics. Late-cycle dynamics include banks incrementally restricting business lending. Mid-cycle dynamics include banks continuing to ease mortgage lending standards and the Federal Reserve (Fed) lowering its forward rate-hike guidance to a more gradual pace.6 After deteriorating sharply during the first two months of 2016, the Bloomberg Financial Conditions Index returned to positive territory in March, suggesting the overall level of financial conditions in the U.S. is once again accommodative.7 Headwinds to the credit cycle have risen, but stabilization in the global economy and financial markets may be helping mitigate some of those pressures.
Global: Weak growth, but signs of stabilization emerging
The global economy is struggling, but there are some signs of stabilization. Less than half the world’s largest economies posted positive growth in leading economic indicators (LEIs) on a six-month basis, but emerging markets have recently shown some improvement.8 In a sign the global trade and industrial recession may be ebbing, 90% of the largest economies now have positive manufacturing bullwhips (the new orders less inventories component of purchasing manager indices)—a favorable leading indicator of manufacturing activity.9 Global growth remains tepid, but indications of stabilizing activity are rising.
Monetary polices are accommodative, but negative rates show the limits
Easy monetary policies continue to support global financial conditions, including a more dovish Fed outlook that has eased the pressure of tighter U.S. dollar liquidity. However, negative policy rates in Europe and Japan may be demonstrating the limits of monetary policy’s ability to boost economic growth. In theory, negative rates are designed to stimulate bank lending, reduce corporate debt-service burdens, and incentivize consumption by reducing the reward to savings. In practice, however, negative rates hurt bank profit margins and may deter lending, lower productivity by keeping weak firms in business, and create an incentive for households to save more due to the low returns on fixed-income assets. Furthermore, negative rates are likely designed to weaken currencies in order to improve export competitiveness, but both the euro and yen have strengthened since negative rates were pushed lower in recent months. Negative policy rates may not support their intended goals, but global financial conditions have improved in recent weeks.
Europe remains in a tepid, mid-cycle expansion. The negative impact of the weak global environment, which had caused consumer confidence and industrial business expectations to decline in Germany, has potentially stabilized in recent months.10 Despite weak activity to start the year, supportive monetary policy and a steady backdrop for the household sector suggest a low probability of recession in the short term.
As a slow-growing economy heavily reliant on trade, Japan’s business cycle is particularly susceptible to changes in the external growth environment. Japan, like Europe, has a weak industrial sector and a central bank attempting to stimulate with negative interest policy rates. Japan, however, is further along in its cycle due to higher exposure to Asian trade and is achieving less benefit from additional monetary support. The trajectory of Japan’s late-cycle economy may depend most on trends in the global economy.
A downshift in growth at the end of an overextended credit boom has caused China to remain in a growth recession for the past year, but recent signs suggest a possible bottoming in near-term activity. The increase in fiscal stimulus has begun to positively affect real estate construction and infrastructure activity. These signs of stabilization and tighter capital controls have helped capital outflows slow in recent months, reducing the near-term risks to China’s financial stability. Rising support from policymakers should help stabilize conditions in the near term, although greater structural reforms will be needed for a sustainable reacceleration.
Outlook/asset allocation implications
Financial markets calmed down after a turbulent start to the year. The better tone was due in part to indications that economic fears had been overblown, while additional policy easing— particularly a more dovish outlook by the Fed—also helped improve global financial conditions.
At this point in the business cycle, progress in the U.S. labor markets is a double-edged sword. Continued job and income gains are a key ingredient to bolstering consumption and keeping the odds of recession low. However, accelerating wages also boost inflationary pressures and are a classic late-cycle signal. It’s important to note that the late-cycle phase has not typically implied a steep downturn in the economy or markets, and that the eventual transition to recession has at times taken more than two years (see “March business cycle: U.S. recession risks low” for a more detailed report on the implications of the late-cycle phase on asset markets).
From an asset allocation perspective, we expect global economic stabilization to provide support for U.S. and global equities during 2016. The rising probability of the late-cycle transition in the U.S. indicates that smaller cyclical asset allocation tilts may be warranted, and that assets with inflation-resistant properties may provide important portfolio diversification. There appear to be selective opportunities in a number of the most beaten-down asset categories, including emerging-market equities, commodity stocks, and TIPS.
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