Two weeks ago, we reported that according to the latest Bank of America Fund Manager Survey, no less than 74% of respondents answered that the global economy is in "late cycle:" the highest percentage in survey history, while at the same time respondents voiced the highest inflation expectations in over 13 years. As a reminder, when global growth turns south coupled with inflation you get "stagflation", and when the result is an abrupt halt to the "late cycle" economic expansion, recessions begins.
And, judging by last week's market reaction, the broader market is starting to agree that the world economy is if not on the edge of recession (although JPM's observation that the OIS curve has once again inverted for the first time in 13 years is the clearest confirmation of just that), then very, very "late cycle."
It is therefore not surprising, that with a record number of people convinced - and the market now too - that a recession may be imminent, that Morgan Stanley picked the topic of where in the economic cycle we are for its "Sunday Start" piece on what's next in global macro.
As the bank's global co-head of economics, Chetan Ahya, writes this morning, while in 2017, "the global economy roared back to life, as a synchronous recovery in developed (DM) and emerging (EM) markets propelled growth to a 3.7% annual average" this is now decidedly over, having reversed rapidly in 1Q18, "as DM growth has moderated alongside the rising risk of protectionism, renewing concerns over the length of the global expansion cycle." In fact, as we showed last week, the global economic surprise index just turned negative for the first time since July 2017.
And, as Ahya adds, the far "more critical debate, in my view, is how long the business cycle has to run." This is what the Morgan Stanley economist found:
The US and Japan are the primary drivers of the slippage in DM growth. Our US economics team has noted that “residual seasonality” consistently distorts GDP, leading to weak 1Q growth. In Japan, colder weather has dampened private consumption in 1Q18. In Europe, despite moderating PMIs, 1Q18 growth is tracking at an annualized 2.5%Q. In China, our tracking estimate for 1Q18 is now 6.9%Y vs. our initial forecast of 6.6%Y. Our tracking estimate for 1Q18 global GDP growth has drifted lower but still stands at a 3.9%Q SAAR. Cyclically, while we expect China’s growth to moderate, we see DM bouncing back in 2Q, which along with continued strength in emerging markets ex China should keep global growth well supported for the rest of the year.
Here Morgan Stanley shares a broader perspective on recent events, and whether "the business cycle in DM is coming to an end." Repeating that the current cycle is clearly more advanced in DM, and the US is furthest along – hence, where attention has (rightly) focused, the bank's global economic lays out the key parameters it is watching to see if the end of the business cycle is approaching. According to Ahya, the following conditions would be warning signs:
- Resources are stretched. The unemployment rate is very low and wage growth is at cyclical highs.
- Inflation rises slightly above the central banks’ 2% goal.
- The investment cycle is becoming stretched, while corporate profitability is deteriorating.
- The private sector is leveraging aggressively, and excesses are building.
- Central banks take real rates into restrictive territory, slowing demand and causing defaults. This is the piece of the puzzle that brings the business cycle to an end.
So where does the US stand in the context of these 5 signs? Here is Morgan Stanley's take:
- Unemployment gap in negative territory, but no significant wage pressures yet: Headline unemployment in the US has already moved below NAIRU. However, so far in this cycle, wage growth (the more critical metric) has been slow to pick up. Compared to the 2003-07 cycle, wage growth is similar to the pace in mid-2005. In part, the headline unemployment rate may be understating the underlying slack. Indeed, the labour participation rate is far below the pre-crisis peak, and the share of part-time employed workers has been somewhat higher in this cycle.
- Inflation – heading towards but not overshooting central bank goals: We expect core PCE inflation to rise towards 2% from 1.6% currently. While this move will likely cause some anxiety, we view the chances of a significant inflation overshoot relative to target as low and think that the Fed can and will stay on a gradual rate hike path (our base case). To recall, in the 2003-07 cycle, we experienced persistent depreciation in the trade-weighted dollar, a pick-up in wage growth, higher commodity prices and higher non-commodity PPI inflation in China. Yet core inflation rose only to the 2-2.3% range.
- Corporate sector profitability improving; capex cycle still not stretched: Corporate profit growth has accelerated, supported by stronger nominal GDP growth (domestic demand pick-up) and receding headwinds from the EM adjustment and commodity price shock of 2014-16. Capex growth is recovering after two years of downtrend, and the investment-to-GDP ratio remains below previous cycle peaks.
- Aggregate private sector leverage not that aggressive: In this cycle, the household sector been deleveraging until recently but the corporate sector has levered up meaningfully. We note that in this cycle, riskier companies have led the pick-up, hence defaults in the weaker segment of corporate debt could rise as real rates climb above neutral. (Reflecting these concerns, our chief cross-asset strategist Andrew Sheets has been underweight credit in his asset allocation portfolio since November 2017.)
- Real rates not yet in restrictive territory: On our current path for core PCE inflation and Fed policy actions, real rates will be about 25bp above neutral by March 2019 and about 45bp above by mid-2019. In the last two cycles, they rose meaningfully above neutral (to 2% in September 2000 and 1.9% in June 2007) before the business cycle ended 2-3 quarters later.
Needless to say, all these are subjective metrics, and if one had to pick one market-based factor, we would go back to the striking finding by JPMorgan which we noted yesterday, according to which the market is now pricing in just 2 years before either i) the Fed engages in a policy mistake or ii) the Fed's end of cycle dynamics are unleashed, leading to a rate cut and eventually, QE.
Morgan Stanley is somewhat more sanguine: the banks says that "while there are clear signs that we are in the late-cycle phase, some time remains before we near the end of the business cycle. Hence, we think that global growth should be sustained at around a 3.8%Q SAAR over the next four quarters."
Unless, of course, it isn't, and just to cover all bases, the bank lays out potential catalysts that can accelerate the next recession, adding that it remains on the lookout for potential air pockets:
The rise of protectionism has been cited as the most plausible cause of turbulence. Recent developments have increased the risks of further escalation in rhetoric in the coming days and weeks. However, our view remains that the final outcome will be bilateral negotiations. Rather, the most important risk to the business cycle in our view is the potential stress in US corporate balance sheets, particularly in the context of a further rise in real rates.
Morgan Stanley's conclusion? "we recommend that you keep your seat belts fastened."