As the calendar turned to July, the US entered the lon-gest economic expansion in its history.1 While we won’t attempt to predict the long-lived cycle’s eventual end date, certain market and economic dynamics—corporate profit margins among them—suggest that the best part of the current expansion is already behind us. That said, cycles don’t die merely of old age; typically, some sort of shock or unsustainable financial imbalance is needed to trigger their demise. Currently, we see a number of risk factors that could serve as this trigger.
While economic transitions historically have been ac-companied by increased market volatility, the waning days of a business cycle should not be cause for panic.
We believe investments able to demonstrate resilience in the face of cyclical adversity—notably, companies that exhibit scarcity in their business models and thus have the potential for persistent earnings power through an economic downturn—should be well positioned for the more challenging environment that may lie ahead. Fur-ther, the reemergence of more normal levels of volatility could provide active, long-term investors with oppor-tunities to build on or acquire positions in such invest-ments at attractive valuations.
Potential Triggers for the Cycle’s End
The US economy entered the record 121st month of its post-global financial crisis expansion in July,2 and the cycle’s advanced age naturally calls into question its time remaining.
A variety of signals—including weak non-US bank prices, slowing growth in monetary aggregates, flattening yield curves and sluggish inflation expectations—suggest the global economy already has begun to slow, and there are reasons to believe US momen-tum may fade alongside it. For example, profit margins—the heart of the business cycle—may have already hit cyclical peaks, and ongoing capacity expansion in conjunc-tion with expectations for decelerating nominal economic output and limited money supply growth suggest they will remain under pressure. And while risk markets appear complacent, the inverted Treasury yield curve3 suggests traders of government debt have concerns about the US economy’s prospects going forward.
That said, a business cycle’s tipping point often is triggered by the emergence of one or more destabilizing factors. Though we won’t hazard a guess at the catalyst that will turn the current cycle, a number of candidates already have emerged, including:
- Global trade wars
- Mounting challenges in China
- Geopolitical tensions
- US corporate debt vulnerabilities
Global Trade Wars
- Since the beginning of 2018 the US has imposed 25% tariffs on $250 billion of Chinese imports along with duties targeting the import of washing machines, solar panels, and steel and aluminum from most other countries.4 These trading partners retaliated by raising tariffs on imports from the US, and the initial impact of this tit-for-tat can be seen in Exhibit 1.5 Additional tariffs threatened by the US would drive the effective tariff rate to levels that prevailed in the late 1930s and likely have a devastating impact on the global economy.6
- Estimating the broad economic impact of tariffs is difficult, as the costs will be borne by some combination of producers, importers and end consumers. In addition, so-called “second-order” effects—including tariff-related uncertainty that may stifle business investment and consumer spending and weigh on global economic growth and productivity for years to come—can be just as powerful if not more consequen-tial over the long term.
Mounting Challenges in China
- Headwinds have been building in China as the government wrestles with a massive credit boom, a rapidly aging population and its ongoing transition to an open, market economy. Coping with these challenges, on top of the trade tensions with the US, makes China—and thus the world economy dependent on Chinese growth— vulnerable to a policy misstep.
- The rapid increase in China’s private sector debt since the financial crisis, as illustrated in Exhibit 2, has drawn comparisons to the buildup in US debt that ultimately helped instigate the global financial crisis. Nonfinancial corporate debt has risen to about 150% of GDP, and Chinese household debt as a share of GDP is now on par with other developed economies such as Germany and near levels in Japan and France.7
- Recognizing the risks inherent in such a massive credit boom, China has taken steps to crack down on the worst abuses in the financial system—particularly in the shadow-banking sector. Though the encouragement of credit creation has resumed of late, financial stability concerns have prompted restraint from policymakers, sug-gesting Chinese stimulus may not boost the global economy to the extent that it has in the past.
Geopolitical Tensions
- The geopolitical equilibrium has grown more unsteady in recent years, and the escalation of hostilities in any number of areas could cause an economic shock. Perhaps most notable of late has been the persistent ratcheting up of US-Iran tensions; a threatened Iranian disruption of the flow of crude through the strait of Hormuz would likely result in oil price spike—and potentially a global recession.
- More broadly, the traditional world order is being upset by the emergence of popu-list—and sometimes autocratic—politicians and parties across the ideological spectrum. In Europe—which is particularly vulnerable to antiestablishment senti-ment given the persistent and worsening income and wealth disparities among EU (and euro area) members, as shown in Exhibit 3—these changing political winds are threatening the future of the European single market.8
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