Don't Trust Dow 25000. The Economic Cycle Is Broken

The economic cycle has been turned upside down. Depending where you look, there is strong evidence that the U.S. is in the first stage of recovery, in a long mid-cycle, or even approaching the final stages before rolling over.

No wonder investors are confused. Deciding where the country stands in the cycle is a vital part of putting money to work, determining whether it is best to be in bonds, equities or commodities, and which sectors of the stock market are likely to perform best.

At the moment different markets appear to be priced for all parts of the cycle other than recession, while economic indicators, after nine years of growth, point to early cycle again. The blame can be on a mix of eccentric inflation, irregular central banks, and global expansion, and investors have to decide whether there will soon be a return to the usual cycle or if they should rip up the playbook.

The starting place for cycle analysis is the bond market, particularly the slope of the yield curve--the gap between long and short-dated bonds. Last year's three Federal Reserve rate increases were accompanied by flat long bonds, taking the gap between 10 and 2-year Treasury yields to just half a percentage point--where it last stood as the equity market peaked in October 2007. Such a flattening of the yield curve normally suggests the economy's moving into the late cycle, and investors should be taking less risk.

Equity markets sent a different signal. True, large companies beat smaller stocks, which are usually riskier. But the performance was led by high-growth technology companies and by consumer-facing businesses, which usually do best in the early and middle phases of the cycle. There was no sign of a switch to defensive stocks that are able to cope well with the usual late-cycle threats of higher interest rates and weaker growth.

Industrial metals have become a less useful guide to the U.S. economy since the opening up of commodity-hungry China, but the 30% ramp up in prices last year would usually indicate we are either very early or late in the cycle.

"The cycle is much more diffused and dispersed than we've seen historically," says Gregory Peters, a senior bond fund manager at PGIM Fixed Income, part of Prudential Financial. "It's asynchronous, with mini-cycles in commodities and energy."

The economic data are confusing, too. Nine years of growth, albeit much weaker than is normal, should place the U.S. at best in an extremely extended mid-cycle. Instead, the Institute for Supply Management's manufacturing index is surging, with new orders leading the way and no sign of a buildup of unsold inventory. Strong new orders and low inventories presage further growth from restocking, and are a sign of being early in the cycle.

Economic data haven't just been strong, they also have been soundly beating expectations, giving a further boost to growth stocks.

One explanation for the mixed signals is that bonds are distorted, but it also points to risks ahead. Long-dated bond yields are low partly because investors are convinced that interest rates will be permanently lower and inflation has been defeated.

Long-dated bond yields are also being held down by quantitative easing, still under way in Japan and Europe. The Fed has taken baby steps to reverse its bond purchases, but so far the reduction in its balance sheet has been minuscule. Low bond yields in turn make growth stocks--those with earnings far in the future--more attractive.

If inflation comes back or central banks become more aggressive, rising bond yields and higher rates together could hurt these long-duration stocks, and push shareholders toward defensive stocks with more reliable short-run earnings--late-cycle behavior.

However, the cycle itself could be misleading. The U.S. economy is being lifted by the recovery in the rest of the world, much of which has experienced one or even two recessions since the last U.S. slump ended in 2009. Improved prospects abroad weakened the dollar, which helps explain the strong gains for U.S. stocks. In constant-currency terms and including dividends, the S&P 500 was beaten by eurozone, Japanese, U.K. and emerging market stocks last year.

Global growth, together with the falling away of concerns about China's debt pile, helps explain the gains for metals prices, too.

Maybe the U.S. is just a year or so into a new mini-cycle, likely to be further supported by corporate-tax cuts. If so, this mini-cycle starts out with the advantage of low inflation but the disadvantages of already-low unemployment, high corporate debt and a Fed set on a tightening path.

There is little reason to think recession is imminent. Whether this is a new mini-cycle or a mixed-up superlong cycle, any hint of inflation is likely to prompt worries that the cycle is maturing, push up bond yields and hit tech and other growth stocks.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

January 05, 2018 10:46 ET (15:46 GMT)