Fin de Cycle? Non
This post is a guest contribution by Joachim Fels & Spyros Andreopoulos of of Morgan Stanley.
Doubts abound: Only two years into the recovery from the Great Recession, doubts abound whether the expansion in the advanced economies is sustainable. Are we already heading into a new downturn over the next year or so, or is this just a soft patch in an enduring expansion?
Too young to die… By the standards of post-war cycles, this recovery is much too young to die. According to the NBER’s business cycle dates, the average post-1945 expansion in the US has lasted five years (59 months to be precise). Global expansions have lasted even longer – around six years on average in the four expansions following the mid-1970s recession. The shortest of these global expansions, in the late 1970s, lasted four years, twice the age of the current expansion.
…or back to shorter pre-war cycles? Yet, some observers have pointed out that we may be seeing a return of the shorter pre-war business cycles. In fact, in the six US cycles between 1919 and 1945 recorded by the NBER, expansion phases averaged only three years (35 months), and in the 16 cycles from 1854 to 1919, expansions only lasted 2.25 years (27 months) on average.
Those times were different: In our view, however, there are several reasons why the shorter pre-war cycles are not a good guide for present times:
1. Monetary policy back then was constrained by the gold standard most of the time, so central banks’ ability to smooth and manage the cycle was extremely limited (and, by the way, the Federal Reserve was only established in 1913).
2. Like monetary policy, fiscal policy was mostly passive – it only became a tool of active demand management following the devastating experience of the Great Depression and the related rise of Keynesian theory and policy.
3. Manufacturing and agriculture, which are inherently more volatile and prone to shorter cycles, accounted for a much larger share of overall output in pre-war times. Thus, the amplitude and duration of pre-war business cycles was shorter than in today’s service sector-heavy economies.
Post-credit bust recoveries may be a better guide: A better guide than the pre-war experience to how the present cycle will evolve may be the recoveries that followed major credit and banking sector busts in other advanced economies over the past several decades.
‘The Big Five’ and ‘The Last Four’: More than three years after Carmen Reinhart and Ken Rogoff first compared the US downturn to the five biggest financial crises (‘The Big Five’) in industrialised countries over the past few decades (Spain 1977, Norway 1987, Finland 1991, Sweden 1991 and Japan 1992), it is instructive to compare the evolution of the ensuing recoveries with the present one and the average of the last four US recoveries (‘The Last Four’). The recoveries following ‘The Big Five’ were unsurprisingly more sluggish than the recoveries following ‘normal’ recessions – an observation that informed our (still valid) baseline view back in 2009 that this recovery in the advanced economies would be BBB in nature – bumpy, below-par and brittle.
Clearly worse than ‘The Last Four’ but slightly better than ‘The Big Five’: In fact, while the current US recovery looks decidedly sub-par compared to ‘The Last Four’, it compares somewhat favourably with ‘The Big Five’. While the recent recession was deeper than in ‘The Big Five’, the following rebound was steeper. This likely reflects a much more aggressive fiscal and monetary response this time round. Importantly, while the recoveries following big financial crises were less vigorous than those following garden-variety recessions, they were not typically shorter than normal recoveries. This is probably because economic policies remained supportive for longer following financial busts in order to offset the obvious headwinds from deleveraging.
BBB yes, but not necessarily shorter: So, to conclude the comparison, while there are good reasons to expect this recovery in the advanced economies to remain sub-par, or BBB, in nature, the experience with other financial bust episodes does not suggest that it will necessarily be shorter than ‘normal’ recoveries.
Policy and EM to prolong expansion: Moreover, in our view, there are two important factors that will keep this recovery on track for longer: ongoing policy support, especially from monetary policy, and ongoing support from EM growth and global rebalancing.
Real rates, the yield curve and M1 signal anything but recession: Regarding monetary policy, recessions are usually preceded by fairly aggressive monetary tightening and signaled well ahead by a related inversion of the yield curve. Past US recessions followed sharp increases in real short-term interest rates and inversions of the 10-2Y Treasury yield curve. Right now, real short rates remain in negative territory, and the yield curve is close to record steepness. Another (less reliable but still instructive) indicator – real M1 growth – also signals expansion rather than recession.
Pull from EM rebalancing also helps: The second factor that should support continued expansion in advanced economies is what we think is a sustainable recovery in EM economies, where policy-makers are currently engineering a soft landing in order to keep inflationary pressures under control – in conjunction with global rebalancing. The ongoing rebalancing of China and other export-driven EM countries towards domestic consumption should help the rebalancing in deficit countries such as the US, where the main driver in this expansion will likely be exports and capital spending, reflecting a competitive currency and a healthy corporate sector with plenty of cash on the balance sheet.
Slower but healthier: It is important to emphasise that global rebalancing – a process that has just begun – should make for a more sustainable recovery even if its speed is lower than usual. That is, the quality as well as the quantity of growth matters: by returning the global economy to a healthier structure (higher consumption, lower exports in surplus economies and vice versa in deficit economies), the expansion should, in the medium term, be on a firmer footing. Put differently, a shallow recovery due to imbalances working themselves through is preferable at this stage to a roaring recovery predicated on the expansion of existing imbalances; such an expansion would merely contain the seeds of its own destruction, in our view.
Mercy, mercy: The above, of course, also means that the DM expansion is likely to be at the mercy of: (1) policy-makers’ continued willingness to keep stimulus in place; and (2) ongoing EM growth and rebalancing. Regarding (1), we think that policy-makers have learned the lessons of previous policy-aborted fragile recoveries, namely the Fed’s tightening of reserve requirements in the wake of the Great Depression in 1936/37 which contributed to the 1937 recession, and the BoJ’s premature exit from ZIRP in the early 2000s, as well as the big increase in Japan’s VAT in April 1997. On (2), we think that EM growth will continue to be both strong and sustainable – not least because it has led to and should continue to benefit from greater institutional and social stability. As for global rebalancing, we think it is inevitable and inexorable – though of course it will not occur in a straight line.
Bottom line: Fears that the present recovery in the advanced economies will roll over any time soon are exaggerated, in our view. While this expansion, like all expansions following a major credit bust, was always going to be bumpy, below-par and brittle, we think that: (i) ongoing policy support from policy-makers that have learned the lessons about premature tightening in the past; and (ii) the beneficial effects of EM and global rebalancing will make for a healthier, albeit less vigorous, expansion.
Source:Joachim Fels & Spyros Andreopoulos, Morgan Stanley, June 17, 2011.