Did the current economic cycle skip a recession?
The economy has been flowing along for quite some time, and many are wondering how much longer this forward momentum will last. The longest economic expansion in U.S. history lasted 10 years, occurring from 1991 to 2001. However, this could change over the next year. (December 2018)
If the U.S. avoids a recession — defined as two consecutive quarters of negative economic growth based on gross domestic product (GDP) — through July 2019, we will set a record for our country’s longest economic expansion.
However, there is some evidence suggesting that the economic cycle clock should have been reset in 2016 due to a pause in economic activity. Maybe we saw an economic soft landing in 2016. Soft landings are rare and thus difficult to identify.
Understanding the economic cycle
Economic cycles are easy to understand … after they have happened. First there is a recession as GDP contracts, then comes the recovery and robust economic growth, followed by an expansion and then the cycle completes with a recession.
The current cycle began with the Great Recession (2007-2009), and what followed is interesting. Unlike other periods, there was no Great Recovery and no Great Expansion; rather, we’ve witnessed the Great Moderation, experiencing an average 2.3 percent real GDP growth since 2009. We still see no sign of a recession on the 12- to 24-month horizon.
Soft landings defined
An economic soft landing is a cyclical downturn that avoids a recession. Historically, a soft landing includes the Federal Reserve (the Fed) hiking short-term interest rates just enough to prevent the economy from growing too fast, yet avoiding a contraction in GDP. Soft landings don’t happen very often and can be difficult to identify. In 2015 and 2016 we saw these components, and yet things slowed down without a recession.
Soft landing reset
The following data points support the idea that the economy experienced a soft landing in 2015 and 2016, thus resetting the cycle clock. Therefore, the U.S. economic cycle may be in its second or third year of expansion, rather than its tenth.
Interest rates and fed funds
Short-term interest rates and federal funds (fed funds) decreased to 0.25 percent in late 2008, or virtually zero. It was the Fed’s tenth rate cut in a little over a year. Quantitative easing, the Fed’s bond purchasing program, began in late 2008. In December 2015, the Fed hiked rates by 0.25 percent, starting a potential tightening cycle. At the beginning of 2016, the Fed announced they would hike rates four times throughout the year. However, due to a slowing economy and a debacle in the equity markets, the Fed only hiked once that year, in December 2016. The Fed exercised a “tactical stall.“ The economy slowed down in 2016, it looked and felt like a recession, but the economy didn’t contract.
Industrial production (IP) measures changes in only the volume of goods produced—it doesn’t include the price of goods, removing the potential distortion of inflation. In 2014, IP began a sharp decline, decreasing 4.0 percent in 2015. This was the first time in at least 50 years that IP was negative without a declared recession. GDP in the fourth quarter of 2016 was a paltry 0.4 percent. For the 2016 calendar year, real GDP increased only 1.6 percent. It felt like a recession, but officially the economy didn’t experience a recession.
In late 2014, S&P 500 earnings entered a recession. There were seven quarters of earnings contraction; we didn’t see earnings growth again until the third quarter of 2016. The primary driver of the contraction was falling oil prices and a strong dollar.
Compare this to the 1991 expansion: earnings growth remained negative for the entire year. But after that, we didn’t see two consecutive quarters of earnings contraction until the fourth quarter of 2000, prior to the end of the cycle.
Bear markets (when markets are down more than 20 percent) are associated with recessions, and equity markets are leading indicators. From June 2015 to February 2016 the Russell 2000 was down 26 percent, with the S&P 500 down only 13 percent. The equity markets “kind of” suggested a recession was on the horizon. It’s possible the S&P 500 didn’t enter bear market territory because the Fed was accommodative. Fed funds were at 0.50 percent at the beginning of 2016, and as I mentioned, the Fed announced a tactical stall by not raising rates again until December.
Toward the end of the 1991 to 2001 expansion, the stock market indicated a recession was looming. In early 2001, the S&P 500 and the Russell 2000 posted year-over-year returns of negative 28 percent and negative 30 percent, respectively. The recession officially started in March 2001, marking the end of the longest economic expansion in U.S. history.
From 2014 to 2016, some sectors weren’t in a recession, but rather in a depression. Take the energy sector, for example. Oil was very volatile, down 46 percent in 2014, down another 30 percent in 2015 and then up 45 percent in 2016. A similar pattern was witnessed at the end of the longest expansion, 1991 to 2001. In 1997 oil was down 32 percent, down 32 percent the next year, and up an astonishing 112 percent in 1999. Then the recession started in March 2001. The point is, historically, a debacle in commodity prices appears to coincide with the end of the cycle, supporting the idea that the U.S. economy experienced a soft landing in 2016.
Many experts suggest watching the bond market for clues regarding economic conditions and risk exposure. In mid-2014, credit spreads on investment grade and high-yield bonds changed course. Spreads started to widen, which is considered standard operating procedure as the economy slows and a recession looms. Spreads continued to widen through early 2016, peaking in a similar way to a recessionary period.
In a period of recession, bond default rates increase. Default rates bottomed in early 2015, then spiked higher through mid-2016. The previously mentioned falling oil prices had something to do with this. There were numerous defaults in the energy space. Nevertheless, there was no recession.
What happened in 2015-2016
As far as the economy is concerned, the question is: Did we see an economic soft landing in 2015-2016? Should the economic cycle clock have been reset, starting a new cycle?
Either way, it doesn’t matter. Whether we’re in a nine-and-a-half-year or a two-and-a-half-year expansion, the data clearly indicates the economy slowed down in 2016, perhaps reducing the potential of overheating and diminishing the risk of asset bubbles and economic imbalances. If the current economic expansion is only in year 2 ½, then the expansion should continue for several more years. If the expansion is in year 9 ½, the current economic data suggests the U.S. economy should continue to expand well into 2019.
Regardless of the camp you’re in, we expect the economic expansion to continue well into next year, perhaps longer, and will be deemed the longest expansion in U.S. history. We expect economic activity to slow next year, perhaps continuing the Great Moderation.
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