Equity Investment Outlook July 2019

During the second quarter, the stock market continued to rebound from last year’s fourth quarter swoon. This reflected the recognition that neither the trade war nor Federal Reserve (Fed) monetary policy was about to torpedo the long, slow recovery from the 2008 housing debacle. U.S. domestic economic growth remains steady and non-inflationary. The pace of economic activity moves up and down quarter-to-quarter, but remains positive. This raises two questions: 1) What happened to the business cycle? and 2) Where is inflation?

On the one hand, this recovery cycle is unique in that it was preceded by a massive housing boom and ensuing bust. Recall that the housing boom was fueled by a ludicrous lowering of credit standards and an irresponsible leveraging of the banking system. When the boom turned to bust, the banking system was severely crippled and was forced to deleverage, resulting in a long period of sub-trend housing activity, tighter lending standards, and weak growth in bank loans. As a result, the velocity of money – a key driver of inflation – declined.

On top of this idiosyncratic aspect of the recovery, there were powerful structural shifts within the economy, which have also kept a lid on the speed of the expansion and on inflation, and thereby enhanced the durability of the recovery. It is here that we want to focus today. We are now ten years into an expansion and yet we see no real signs of an imminent recession. There have been periods of slowing growth, but no recession. Slowdown maybe, recession no.

What happened to the business cycle? Historically, the business cycle could be thought of as a giant inventory cycle, which could be quickened or slowed by monetary and fiscal policy shifts.

Historically, the Fed would lower interest rates during a recession to stimulate housing and auto demand. And Congress might do some deficit spending to create additional demand. These actions would get the economy moving. Usually the recovery would be sharper than our recent experience and bottlenecks would appear. Buyers would begin double ordering goods they needed to make their products. Wholesale prices would move up – as would retail prices – and inflation would start to accelerate. Higher prices would cause manufacturers of intermediate goods to expand capacity. Producers of finished goods would see their orders filled and suddenly they would be saddled with more inventory than they wanted – remember they had double ordered. So, they stopped ordering. As a result, manufacturers of intermediate goods would see orders plummet and they would respond by shutting down production lines and laying off workers.

Meanwhile, the Fed would have become concerned about inflation and would have started to raise interest rates to choke off homebuilding and autos. As housing and auto demand collapsed, more workers would be laid off and “voila” we would be in recession. And then the whole process would start over. A few years of boom, a year or two of bust, and back to boom, etc.

This boom/bust cycle seems not to work anymore. According to the Wall Street Journal (6/18/19), construction and manufacturing jobs accounted for about 25% of total U.S. employment in 1980. Now they comprise only 13%. This means that the boom/bust cycle that we described above does not have nearly the same impact as it used to.