The north star of the economyContributor Dr. David Kelly
For mariners of antiquity, Polaris, otherwise known as the North Star, was the most important guidepost in the heavens. Almost directly aligned with the earth’s axis, its position in the sky never varied. If it was to starboard, you were sailing west. If it was to port, you were headed east.
Investors need a North Star too — some reliable way of assessing where we are in an economic expansion. In particular, it’s important to know how much longer an expansion is likely to last since the recessions that follow are always associated with significant stock market declines.
However, each expansion seems fundamentally different and this one is particularly puzzling.
Chronologically, this expansion is old. It has now lasted into its 77th month, making it the fifth longest of the 34 expansions since 1900. Looking at lightvehicle sales, at over 18 million units annualized in each of the last two months, we should be close to a peak. Housing starts, however, remain well below their long-term averages, suggesting years of expansion to come, while interest rates and inflation are at levels normally associated with early expansion. Moreover, all of these measures are severely distorted by extremely aggressive monetary easing.
However, there is one “North Star” variable that has behaved in almost the same way in all modern expansions, namely, the unemployment rate. The one nearconstant in the American economy is the speed at which the labor market heals itself. In the seven expansions since 1960, the unemployment rate has fallen at an average pace of 0.7% per year, ranging quite narrowly from a 0.5% annual decline in the expansions of the 1990s and 2000s to a 0.9% pace of decline in the expansions of the late 1970s and 1980s.
The October employment report confirmed that the unemployment rate has now been falling for six years at a steady pace of 0.8% per year and has now declined to 5.0%. Slow labor force growth and steady economic growth suggests a continuation of this pace, which would put the unemployment rate at 4.2% in October of 2016 and 3.8% in April of 2017.
It is important to note that the average trough unemployment rate over the last seven expansions has been 4.5% and that, while the unemployment rate hit 3.4% in the late 1960s, the lowest trough since then has been the unemployment rate of 3.8% in April 2000. Despite the slow pace of wage gains to this point, it is doubtful that the U.S. unemployment rate can be pushed below 3.8% without a serious wage inflation problem. Consequently, it is reasonable to assume that we are within 18 months of a trough in the unemployment rate. As the U.S. economy closes in on this level, it is likely that the Federal Reserve will slowly increase interest rates, trying to engineer a “soft landing.”
None of this sounds particularly ominous except for the fact that the Federal Reserve has never actually succeeded in achieving a “soft landing.” In fact, since 1960, we have found ourselves in recession just eight months on average after hitting a trough on unemployment. The longest an expansion has lasted beyond an unemployment rate trough has been 16 months; the shortest has been just one month.
The lack of soft landings is an issue worth exploring in more depth. One possibility is that an economy with stable, rather than falling unemployment, is necessarily growing more slowly and a slow-growing economy, like a slowmoving bicycle, is easier to upset. Another is the increasingly biting effects of interest rate increases as they are raised from higher levels. Because of lagged and non-linear effects, the Federal Reserve is generally too slow to tighten at the start and too aggressive in tightening at the end.
Clearly the issue deserves more study. However, from an empirical perspective, it appears that, while this expansion still should have some room to run, the pace of unemployment decline points to a significant recession risk in 2017. It should also be noted that all major recessions in the last 50 years have been accompanied by a severe market correction or bear market and that stock market peaks tends to lead business cycle peaks by a few months.
None of this suggests an imminent economic threat to the current stock market. However, it does suggest a need to watch the unemployment rate carefully in the year ahead to see how quickly it is approaching a trough and how that is impacting the U.S. economy. While current valuations suggest investors should still be overweight equities relative to fixed income, further equity gains with rising interest rates in a clearly aging expansion will require a frequent reexamination of appropriate asset allocation.
Any performance quoted is past performance and is not a guarantee of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
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