Economic growth in the U.S. and Europe has accelerated since the beginning of the year. Here at home, growth has accelerated from below to above 2%, while in Europe growth has gone from below to above 1%. Late in this business cycle, the difference between good and slow growth remains small. Let’s examine the shallow cycle we’re in to see what may remain for the rest of 2017.
There are structural factors, such as the transition between mega-generations (the millennials and baby boomers) and the reduction in inflation that comes from innovative technologies (such as cost pressure on cable providers due to low cost streaming platforms like Netflix and Hulu). These structural issues have and will affect the business cycle for years.
There are many business cycle factors that affect the rate of economic growth nearer-term. Some of these include interest rates, inflation, wage growth and business confidence. As noted earlier, we’ve seen an acceleration in economic growth stemming from an improvement in some of these factors which began improving over a year ago. Sometimes there is a lag between when factors change and the benefits occur through a higher economic growth rate.
Interest rates represent a factor where change affects the economy with a six- to 18-month lag. This represents the cost of capital for most individuals and businesses. As a result, the more expensive capital becomes, the higher the return on that capital needs to be. If businesses are concerned about their ability to earn a reasonable return, they may be less likely to borrow at higher rates, and that slows the economy. Individuals may view their return differently, but they still require something when the cost is higher. For example, if the cost of borrowing money for a home increases, then either the buyer needs to feel that the price will appreciate at a reasonable rate to compensate or they may buy something less expensive.
The rise and fall of interest rates, then, changes the attractiveness of borrowing money. With rates so low, you wouldn’t think a small change matters, but we have evidence to the contrary. Over the last three years, as rates have risen and fallen, we have seen a change in the rate of economic activity 12 to 18 months later. In the last three years, the interest rate on the 10-year Treasury has mostly moved between 1.5% and 3%. With each of the moves higher or lower, the rate of economic growth 12 months later has risen or fallen. As an example, during the first half of 2016, interest rates fell from near 2.25% to near 1.35%. Subsequently, economic growth has picked up from below to above 2% during the first six months of 2017. Interest rates have traded lower during the last five years, but they seem to trade above and below 2.25%. Evidence of the shallow business cycle can be seen using interest rates. When rates rise, the economy slows within six to 18 months and vice versa.
Because the structural forces we mentioned earlier keep us locked in this shallow cycle, a factor like interest rates may continue to have control over the direction of growth.
We can see this shallow cycle taking place in economic data that represents how businesses are doing. Last week we received an update on “Durable Goods,” a number that provides some insight into how business spending and new orders are doing. You can see how this figure has moved over the last 20+ years in the chart below. Generally, the dollar amount expands steadily until a recession takes place (the vertical gray bars represent a recession). However, you’ll notice that since 2012, the rhythm of the data echoes the shallow business cycle.
You can see a similar pattern in this chart from the Organization of Economic Cooperation and Development (OECD). It measures the level of confidence among U.S. manufacturers, and the same pattern as that above can be seen.
You’ll notice that the confidence index accelerated late in 2016 before dipping late in the first quarter of 2017. The confidence boost that came from the election waned as the “politics as usual” approach to health care and tax reform caused business owners some concern. However, the evidence suggests that with deregulation providing a more opportunistic environment for growth, in conjunction with improved economic activity, confidence has risen again.
We expect this shallow business cycle to continue and believe it’s possible that it will hold a recession off for another year, maybe two. In the meantime, we will continue to monitor the factors affecting the shallow business cycle and make portfolio changes accordingly.