Fueled by a trifecta of accommodative monetary policies, large fiscal stimulus measures, and the presence of a vaccine, the global economy continues to stage a once-in-a-lifetime recovery after a once-in-a-lifetime crisis. And the vaccine represents the most important catalyst to the position our society finds itself in today — moving from a recovery to a possible expansionary re-opening.
In this charting the market, I will utilize our preferred metric for US business cycle analysis to understand if we have entered an expansion while discussing how to possibly position portfolios in the environment from a sector perspective.
Dissecting the Business Cycle First published by the US Department of Commerce as part of the Business Cycle Indicators program in the late 1960s, the Conference Board’s LEI Index (LEI) aggregates 10 economic indicators — ranging from employment, business orders and financial conditions to consumer expectations — to summarize common turning-point patterns in economic data. The indicators included in the composite index have survived a wide variety of statistical and economic tests such as consistency, economic significance, statistical adequacy, smoothness and promptness.
Most of the research on business cycles defines only recession and expansion by identifying peak and trough. However, we believe there are nuances in different stages between a peak and a trough. Therefore, we divided the business cycle based on the direction and magnitude of changes of the Conference Board LEI Index.
Recession: The LEI declines to a trough at an accelerating pace
Recovery: The LEI rebounds from a trough but below long-term trends1
Expansion: The LEI year-over-year (YoY) changes are positive and above long-term trends
Slowdown: The LEI YoY changes pass the peak and begin moderating
The chart below shows the delineation between these parts of the cycle and the changes in the LEI. As shown, with economic data improving in the US, the economy may have indeed entered an expansion based on this one metric.
Conference Board LEI YoY%
Expansion Expectations The larger question, however, is will it be sustained? To be fair, the acceleration is a result of the strengthening economic data. But it is also from the low-base effects from the starting point from one year ago. As shown above, the LEI YoY change increased at the fastest rate in history (a 9.45 percentage point change). So, in terms of sustainability it may not continue at this hyper-pace, particularly as there was a weak April jobs report.2
Yet, it does not mean this positive relay handoff from recovery to expansion will be short-lived or bungled — especially since there is roughly $2.6 trillion of excess savings3 sitting on the sidelines. As shown below, the percent of savings of disposable income still sits well above normal levels. As doors begin to fully re-open, this cash could start to filter down into the real economy, accelerating the burgeoning economic expansion.
Source: Bloomberg Finance, L.P. as of March 31, 2021.
There are also some positive signs from alternative data, both in terms of our current progress and the potential path ahead. Businesses, storefronts, restaurants, hotels, and event locations are all starting to increase capacity and re-open their doors to society — evidenced by US mobility improving, with visitors to parks, places of retail and recreation improving the most.
Yet not all mobility trends are back above pre-pandemic levels, as shown below. More vaccinations should lead to a faster and more sustainable re-opening, however. President Biden has called for at least 70% of American adults to have one dose of the vaccine by July 4th,4 potentially accelerating these mobility trends and the economy — strengthening the case for this current potential expansion.
Source: Global Mobility Report, Google as of 04/27/2021. The data shows how visits to places, such as grocery stores and parks, are changing in each geographic region. Retail and Recreation = Mobility trends for places like restaurants, cafes, shopping centers, theme parks, museums, libraries, and movie theaters. Grocery & Pharmacy = Mobility trends for places like grocery markets, food warehouses, farmers markets, specialty food shops, drug stores, and pharmacies. Parks = Mobility trends for places like national parks, public beaches, marinas, dog parks, plazas, and public gardens. Transit Stations = Mobility trends for places like public transport hubs such as subway, bus, and train stations. Workplaces = Mobility trends for places of work. Residential = Mobility trends for places of residence. Data points are a rolling seven-day average to reduce cyclical swings.
Sectors for an Expansion In an expansion, rosy economic prospects and increasing corporate profits typically push companies to begin to allocating capital to expand business and improve productivity to meet increasing demand. And in a previous paper, we dissected sector performance through various business cycles over the last sixty years, identifying that, on average, Financials, Technology, and Communication Services sectors performed the best — with the latter two benefiting from increased capital expenditures and business services spending. Conversely, Consumer Staples, Health Care, and Utilities, on average, performed the worst.
In our current market, those poor expansionary segments are the three worst performers year to date — confirming prior historical trends. However, for the top performers historically, only Financials resides in the top three in terms of year-to-date performance currently. This speaks to a) how every cycle is different, and b) how early it is in this potential expansionary phase. After all, the LEI only triggered an expansion just recently. So it’s not a surprise to see recovery segments (Materials and Industrials) performing strongly so far this year.
Into the Expanse While positivity surrounds the notion of a great re-open, as it should, the hopeful path ahead is still somewhat unknown. While the change in the LEI indicates we have shifted from recovery to expansion, it was just one quarter’s worth of data. Yet, the signs are positive that the year-over-year change will still follow an expansionary pattern, given the amount of pent-up demand on the sidelines — both in terms of money and mobility.
Looking ahead, while beta will be rewarded against a robust economic expansion, this will likely be a “more than just basic beta” rally with cyclical segments of the economy likely to benefit first. From a style perspective, that means value and small-cap exposures may outperform their growth and large-cap counterparts. And at the industry level, retailers, homebuilders, miners, and banks may be seeing some of the earliest demand.
1When identifying recessionary periods, we made small adjustments to the beginning month to match with the economic peak identified by the National Bureau of Economic Research. The adjustments make the beginning month of recessions more aligned with the market downturn. 2“U.S. Job Growth Disappoints in Challenge to Economic Recovery,” Bloomberg, May 7, 2021. 3"Americans are sitting on $2.6 trillion in excess savings from the pandemic that can help power a recovery, Moody's says," Business Insider, April 19, 2021. 4"Biden Sets New Goal: At Least 70% Of Adults Given 1 Vaccine Dose By July 4," NPR, May 4, 2021.
Ten Indicators in the LEI 1 Average weekly hours, manufacturing
2 Average weekly initial claims for unemployment insurance
3 Manufacturers’ new orders, consumer goods and materials
4 ISM Index of new orders
5 Manufacturers’ new orders, nondefense capital goods, excluding aircraft orders
6 Building permits, new private housing units
7 Stock prices, 500 common stocks
8 Leading Credit IndexTM
9 Interest rate spread, 10-year Treasury bonds less federal funds
10 Average consumer expectations for business conditions
During a recession, economic activities fall significantly across the board, with declining economic outputs and aggregate demand from both consumers and businesses.
During a recovery, the economy rebounds sharply from the bottom, but below trend.
Economic growth reaches the cycle peak.
Slowdown Capacity utilization usually reaches cycle peaks and economic output gaps turn positive, meaning the economy is running beyond full capacity.
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