We expect this U.S. expansion to last for years. Here's why.
Consumer spending, boosts to productivity and an accommodative Fed may help keep the economy healthy.
We think there is still more sand left in the U.S. economic hourglass before this cycle runs out—and we suggest that investors use this time wisely.
More specifically: We believe the U.S. economy will likely be in a “mid-cycle” environment by the end of the year, and that this mid-cycle will be measured in years rather than quarters. It is almost impossible to know what the future holds, but given what we know now, we think it will be the middle of this decade before the economy enters a “late-cycle” phase.
All of this, we think, bodes well for investors in multi-asset portfolios. In prior work, we have shown that mid-cycle environments tend to be lucrative for equity investors, as earnings growth delivers price gains. Further, as longer-term interest rates rise, fixed income becomes a more compelling option for investors.
But, critically, active management becomes key when securities across asset classes are moved by drivers that are more sector- and company-specific. And as we move into mid-cycle, investing becomes more micro.
Where we believe we’re headed
To know where we’re headed, we first have to know where we are in the business cycle. While identifying where we are in the cycle is never an easy task, the pandemic adds greater complexity. COVID-19 restrictions have helped create a continuing boom in durable goods such as used cars and the housing sector, while depressing high-contact services such as live entertainment and commuting-related sectors.
Even though new variants of the coronavirus may continue to pose risks to the economy, investors are likely to shift their attention in the coming quarters from epidemiology to factors that traditionally drive the economy and markets. That is to say: Instead of COVID cases and hospitalization rates, we expect investors to focus on GDP growth, employment rates, monetary policy, earnings, etc.
Assessing where we are in the cycle
How long might the coming “mid-cycle” last? There are currently two major schools of thought. One posits that high inflation will force the Federal Reserve to raise rates to slow the economy as soon as next year (leading to a short mid-cycle). The other says the U.S. economy will repeat the slow and sluggish mid-cycle environment of the post–global financial crisis cycle that kept investor enthusiasm and interest rates in check.
We think the answer likely lies somewhere in between. Sufficient fiscal support coupled with productivity gains made during the crisis will drive a recovery that is more robust and shorter than the recovery from the global financial crisis. As a result, we believe, this mid-cycle environment will last into the mid-2020s.
A quicker, stronger recovery would be good news for multi-asset portfolios, as mid-cycles have a self-reinforcing dynamic of spending and income that generates healthy economic growth and solid returns for risk assets.
We see three factors that will help power the coming cycle:
- The consumer is set to spend
- Pandemic-era shifts could increase productivity and GDP
- The Federal Reserve has a more accommodative framework than it did in the past
The consumer is set to spend
There are reasons to believe that U.S. consumption will be strong. U.S. households have accumulated around $2.4 trillion in excess savings. Soaring home and stock prices also mean that wealth is generally at all-time highs. While the distribution of this wealth is skewed toward higher-income households, demand for labor and wage growth should spread the wealth, broadening the power to spend.
More money to spend
U.S. households saved an extra $2.4T during the pandemic
Consumers also have scope to increase their borrowing. Since 2015, debt has been growing at about half the rate of income. Meanwhile, home price appreciation has augmented household assets, suggesting greater borrowing power. Moreover, debt service as a percentage of income is at all-time lows, and lending standards are easing. As excess savings are spent down, leverage might rise to augment incomes and sustain spending.
Pandemic-era shifts could increase productivity and GDP
We see three big, pandemic-induced shifts that could help increase productivity and help sustain this cycle.
- More corporate spending—The surge in demand from fiscal support and increased savings could lead to higher levels of corporate capex. Goods-producing industries (most notably semiconductors) cannot keep up with demand and need to invest in more capacity. Companies in both goods and services industries are also likely to invest in automation.
U.S. companies’ investment in automation is likely to keep increasing
During the pandemic, software and information processing capex as a percentage of GDP shot up—but there is no reason so expect a drop-off anytime soon
- More work hours and workers—More remote work might mean employees will spend less time commuting and women will be better able to participate in the economy. The less time people spend on the trains and roads, the more hours they have to work and the more output they can produce. Remote work also permits a level of flexibility around childcare, a traditional stumbling block for female labor participation. Currently, women aged 25 to 44 years old have a participation rate that is around 12–15 percentage points lower than that of men. 1
- More home buying—Remote work, low interest rates and limited housing stock should support the housing sector. If commuting is not as onerous and mortgage rates keep housing affordable, millennials (who are moving into their middle ages and out of their parents’ homes) might buy houses for their growing families. The only problem is that there aren’t many dwellings available these days. The collapse of the housing sector during the global financial crisis led to more than a decade of underbuilding. Now, demand for homes outstrips supply. Meeting this need will help support the overall economy. The housing sector has a significant ripple effect on the broader economy. For every one housing sector job created, three to five jobs are created in other parts of the economy.
The Federal Reserve is more accommodative
The Federal Reserve is likely to take its time before slowing the economy down, especially as productivity gains could also help keep a lid on inflation.
Interest rates typically determine when the economic hourglass runs out of sand. Simply put: If interest rates are below expected returns, rational actors will borrow to invest in something that produces cash flows with the potential to exceed the cost of borrowing.
Toward the end of an economic cycle, the Fed tends to raise interest rates in an effort to slow the economy to keep inflation in check. Unfortunately, this move tends to raise the likelihood of recession.
The good news for investors is that the Fed has adopted a new framework called “Flexible Average Inflation Targeting” (FAIT) and a renewed emphasis on the labor market that will likely lead it to remain accommodative for longer than it was in prior cycles to ensure a robust labor market recovery that draws workers off the proverbial sidelines.
Investors are still deciphering what FAIT means in practice. In theory, it should to lead to a fed funds rate that is low enough to generate stronger growth and inflation outcomes than investors saw during the last cycle.
There’s a need for active management
Active management becomes more important during mid-cycle environments.
During early-cycle, rising tides raise all boats while the market as a whole benefits from broad-based economic recovery. But as the cycle ages into mid-cycle, broad growth slows, making themes and secular winners more important for outperformance.
For example, the NASDAQ emerged as a big winner in the mid-1990s, the energy sector began to outperform in the mid-2000s, and the FANG stocks (Facebook, Amazon, Netflix and Google, among others) began to outperform in the mid-2010s. It is here where active management historically has helped find the secular winners.
So speak with your J.P. Morgan team about how you might add active management to your portfolio.