- The risk of US recession remains low, but late-cycle pressures such as tight labor markets and monetary tightening have been on the rise.
- Corporate tax cuts have boosted US markets and partially offset these late-cycle pressures, but their effects are likely to fade while monetary policy grows tighter.
- Rising trade risks reinforce late-cycle conditions by amplifying inflationary and profit-margin pressures.
- Relative performance among asset classes has been less consistent during past late cycles, implying smaller cyclical allocation tilts and an emphasis on diversification and inflation protection.
The US has remained on a gradual progression through its business cycle, experiencing mid- and late-cycle dynamics and low risk of recession. Economic growth remains healthy, but late-cycle pressures have recently been on the rise. Most notably:
- Improving job conditions have pushed labor markets even tighter and are now putting upward pressure on wages.
- The Federal Reserve (Fed) has responded by hiking short-term interest rates, and the yield curve has flattened (the gap between short- and long-term Treasury yields has narrowed).
Traditional late-cycle patterns typically include the following:
- A flatter yield curve ultimately leads to tighter credit conditions and higher borrowing rates.
- Higher inflation generally keeps revenue growth elevated, at about 8% on average during the late-cycle phase.
- However, higher wages and interest rates represent increased input costs for businesses. Higher costs tend to erode profit margins and ultimately cause a deceleration in earnings growth, to about 1% on average in the late cycle.
- Growth often peaks during the late cycle even as inflation continues to firm, which has tended to result in a stagflationary backdrop historically.1
So far, the beneficial effects of changes in tax policy that were implemented in early 2018 have partially offset these late-cycle pressures. Most importantly:
- Corporate tax cuts significantly boosted after-tax profits for US companies, reversing the trend of falling profit margins that had been in place since 2015.
- Earnings growth—also boosted by a healthy global economy and a recovery in oil prices—is expected to rise 22% in 2018.2
- Cash from the tax windfall and overseas repatriation has improved creditworthiness and reduced borrowing needs, forestalling any significant tightening of credit conditions.
- Overall, the policy changes injected a healthy dose of mid-cycle dynamism into the corporate sector at a point when the business cycle was maturing.
While ample corporate liquidity has boosted the technical backdrop for US stocks and corporate bonds, the liquidity provided by central banks is dwindling as central banks shift toward monetary tightening.
- Tax cuts and access to overseas cash have reduced the need for corporations to raise capital, resulting in a shrinking supply of corporate bonds and equities.
Those positive technicals have boosted the performance of corporate assets in 2018.
- Meanwhile, major central bank balance sheets grew by roughly $2 trillion in 2017,3 but growth will likely drop to zero by the beginning of next year as the Fed further reduces its balance sheet and the European Central Bank ends quantitative easing.
- Ultimately, we expect the positive tax-cut effect to fade and central bank tightening pressures to build, leading the overall liquidity backdrop to shift from a tailwind to a headwind.
The global business cycle is maturing
We believe the US is advancing in its protracted shift toward the late-cycle phase.
- As the corporate boost from tax cuts fades over the next several months, rising wages and tighter monetary policy are likely to put pressure on profit margins, credit conditions, and earnings growth.
China's late-cycle economy is still slowing, and policy has begun to ease in response.
- Credit, industrial, and fixed-asset investment signals remain extremely weak.
- Policy easing measures take time to show up in activity, and the ability to ease monetary conditions is constrained by tightening global liquidity.
- Similar to 2015, we are concerned that downward pressure on China's currency could spark capital outflows and increase financial stress.
Global activity remains solid, but the pace of growth has deteriorated.
- Manufacturing activity (PMIs) in 87% of the world's largest economies are in expansionary territory; however, only 10% are improving on a 6-month basis.4
- The effect of this deceleration has been most pronounced in export-oriented economies such as Germany, and much of Europe is now demonstrating late-cycle dynamics.
Trade risks have reinforced late-cycle trends
US tariffs, and the retaliatory tariffs of other countries, have so far been relatively limited in scope and size, but the threat of additional measures represent a major risk for the global economy and financial markets.
- In particular, US threats to place additional tariffs on at least $200 billion of Chinese goods represents a potentially severe disruption of the world's largest trading relationship that is also the most interconnected with the rest of the global economy.
- Tariffs on the automobile industry would also be highly disruptive, as its supply chains are heavily integrated throughout the world.
Rising trade barriers tend to strengthen the same late-cycle pressures that have already been gathering steam.
- At a time of tighter capacity, trade disruptions tend to create additional strain through uncertainty, bottlenecks, and supply chain interruptions.
- These challenges often exacerbate inflationary pressures and may also cause deterioration in the quality and certainty of growth.
- Already, micro-level trade effects can be seen across industries that have faced tariffs, including higher prices, longer supplier delivery times, and higher inventories.
Tariffs are a tax whose cost is ultimately born by some entity, and can therefore be tied to inflation.
- As an example, if a US business that pays the tariff on an imported good is able to pass the higher cost on to the final consumer, it results in inflation.
- US washing machine prices, for instance, have risen by 20% since tariffs were implemented in the first quarter.
- If a business is unable to raise its prices, the cost of the tariff is absorbed in the form of reduced profit margins and thus lower profits.
- In the aggregate, trade friction pushes in the same direction as general late-cycle conditions by amplifying inflationary and profit-margin pressures.
The impact of trade barriers is even more acute outside the US.
- China's current account balance is no longer in surplus, implying further damage to the trade account could leave policymakers with less room to maneuver to counteract economic deceleration.
- More export-oriented economies are most at risk, including emerging markets such as South Korea and Thailand, as well as advanced economies such as Germany.
Asset allocation outlook
We don't expect the world to plunge into a 1930s-style global trade war, but we do believe trade policy represents a headwind and will contribute to a continued rise in late-cycle pressures. From an asset allocation perspective, this shift from the mid- to the late-cycle phase has implications for our medium-term views.
The historical business-cycle road map suggests that relative performance among asset classes is much less consistent during the late cycle compared with the mid-cycle. This implies less confidence that riskier assets such as equities will outperform more defensive assets like investment-grade bonds, due to their lower historical frequency of outperforming during the late cycle. In addition, owning inflation-resistant assets such as commodities or TIPS has historically provided some protection against higher inflation risks during the late cycle.
While the US corporate backdrop remains strong and the risk of US recession low, we believe the maturing business cycle and accumulation of policy risks warrant smaller cyclical portfolio tilts at this stage. Facing both downside risks to growth and upside risks to inflation, portfolio diversification is essential at this juncture in the cycle.
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