- Investors are wise to look at more granular classifications of the business cycle and not just relatively infrequent NBER recessions.
- Yield-curve slopes and equity market returns can be used as nowcasting signals to identify turning points of the business cycle.
- Market signals are implying a number of developed markets—notably, Japan, the United States, and Germany—are now entering the correction phase of the business cycle. Trade wars, Brexit, debt issues in Italy and Spain, and political problems in Germany and Italy can make the road ahead a lot bumpier than the road we have grown accustomed to.
The three most common expressions in aviation are: Why is it doing that? Where are we? and Oh crap! — Anonymous
As in aviation, the questions “Why is it doing that?” and “Where are we?” also happen to be very commonly posed by economists and market watchers. For the most part, we never truly know where we are in an economic cycle until after the fact. By that time, if anything meaningful has changed, it’s usually an “Oh crap” moment for investors. Due to the delayed nature of many economic indicators, over the last few years nowcasting has become part of the investment lexicon, especially for market participants looking to get a leg up on the competition and in their own portfolios.
In this article, we show how simple and easy-to-access market fundamentals can be used in real time to identify multiple stages in the business cycles of developed economies, going beyond the usual narrow characterization of recessions. Indeed, for the purpose of investing, we must look at all business-cycle states, not just those identified by the National Bureau of Economic Research (NBER), the entity responsible for dating US recessions, whose motivations may not align with the needs of investors. Hence, we review evidence from bond and equity markets as useful descriptors across all major business-cycle stages. Furthermore, we take a global perspective by applying our findings across 14 major developed markets.
Our evidence shows that bond yields and equity returns can provide clarity as to the current phase of the business cycle, especially during transient states when economies tend to turn the corner on the next phase. Specifically, the slope of the yield curve tends to peak when an economy is rebounding after a recession, and it flattens or inverts when economic growth loses momentum. We also find that equity returns can be used as a second predictor to further refine the identification of the business-cycle stage. These results paired with the most recent market trends imply that a number of major developed markets may be currently entering the correction phase of the business cycle, producing above-potential output, but in the midst of a slowing economy. The good news is that not all corrections turn into fully fledged recessions; the bad news is that the road ahead may be bumpier than what we have grown accustomed to over the last few years.
Throwing Our Hat In The Ring
By discussing market variables and the economy, we join a crowded field. For example, with the recent flattening of the US yield curve, the slope is back in the news, as any search of Google Trends will attest. As a widely accepted predictor of economic recessions, the slope is generally defined as the spread between the yields of the 10-year government benchmark and a shorter-term government benchmark, often the three-month maturity. Historically, a downward-sloping yield curve foretold of higher unemployment, slower real GDP growth, and falling wages and industrial production, and was viewed as a signal for investors to move toward a risk-off portfolio position.
In the United States, the yield curve has been flattening for the better part of the last decade, albeit from a level of significant steepness following the global financial crisis. The most recent march downward started in early 2017 and has taken the yield-curve slope to a point below its long-term average to a level not seen in a flattening cycle since early 2005.
Moreover, the slope is not the only market-based indicator that has been raising concerns. Indeed, the recent jitters across international equity markets have heightened investors’ fears that bad economic times might be just around the corner.
For a larger view, please click on the image above.
Decoding The Business Cycle
In order to understand where we are in the economic cycle, we suggest a simple framework for classifying the various states of the economy over a full business cycle.
In the United States, an NBER-classified recession is a relatively narrow set of events in which a contraction is observed across a wide array of indicators. Since 1953, according to the NBER, the United States has been in recession only 14% of the time; since 1990, this has fallen to 10%. Arguably, a more granular framework than a binary “in” or “out of” recession could be a more valuable tool for investors.
In order to define a set of business-cycle states, we intersect two output-based metrics. The first metric is the well-known output gap, which measures whether the level of production is above or below its estimated potential level, based on data from the OECD (Organisation for Economic Co-operation and Development). We then combine this output-gap data with country-specific slowdowns and expansionary phases as measured by the Federal Reserve Bank of St. Louis (available in the FRED database). These phases indicate the momentum, or speed, at which the economy is running. The intersection of these two measures allows us to classify four stages of the business cycle.