The Narrative Arc

Late-cycle data points are noisy and inconclusive, and the stories we tell about them don’t always add up.

I am not sure when we first used the term “late-cycle” in these CIO Weekly Perspectives, but I do know that its first appearance in a headline was when Joe Amato wrote about “Late-Cycle Dilemmas” way back in November 2017.

Reading that post again, two things strike me:

First, as the current expansion becomes the longest in modern U.S. history, it is a reminder of just how extended each stage of this cycle has been.

Second, Joe was concerned about exuberance in equity markets and the potential for slower growth and higher volatility ahead. It turned out to be a good call.

We have recently pulled together our thoughts on late-cycle dynamics, complete with some ideas on how investors can “survive and thrive” in this challenging environment.

Two of the main themes we uncovered resonate with Joe’s post from 2017. First, how do you act when the near-term outlook ranges from a bullish, last-gasp burst of debt-fueled growth to the bearish shock of markets pricing in the next downturn? A second theme concerned the feedback loops that develop in illiquid, fragmented markets: Prices move out of proportion to fundamental data, which sends apparent signals to investors, who respond by selling when liquidity is fleeing markets.

Those two themes interact. Late-cycle economic data tends to be noisy and inconclusive. As human beings, we like to turn that noise into coherent stories. In late 2016 the story was that China was heading to the rocks. In 2017, and again this spring, we turned to the “Goldilocks meme.” In the second half of 2018 we told ourselves that the global growth engine was sputtering to a halt. We buy the stories, and we create momentum and volatility that is often out of proportion to the data.

Right now, the story investors are telling themselves is one of deflation stalking the world.

The Story Takes Shape

Fed Funds futures now price in as many as three rate cuts in the coming 12 months. The 10-year German Bund yield has spent the past two weeks bouncing around its all-time low of -0.27%.

For sure, the most recent Consumer Price Index (CPI) data in both the euro zone and the U.S. has printed lower, and below expectations. You may have noticed some discussion of the “trimmed mean” CPI. This strips out some of the most volatile elements of the data set, some of which were cited by Fed Chairman Jerome Powell when he characterized the current weak inflation as “transitory.” Last week, this measure did not look any stronger than the headline CPI. In any case, Powell and the Fed just spent two days in Chicago discussing topics such as what maximum employment means in our new, disinflationary environment.

Add all that to a soft nonfarm payrolls print and a dip in U.S. average hourly earnings, and the deflation story takes shape.

These data points are real, but they are not the only data points out there. The latest U.S. Producer Price Index (PPI) paints quite a different picture, for example. Last week’s Job Openings and Labor Turnover Survey (JOLTS) showed employers hiring and employees still just as willing to quit their current jobs for something better. Consumer and business leader confidence remain elevated. And, yes, average hourly earnings had a dip, but is still rising by 3.1% per year. Similarly, inflation index prints are fluctuating by a tenth of a percentage point this way or that way.

Noisy, Inconclusive and Complex

Take a step back, and one could say that we are benefitting from a benign, stable, low-inflation environment. The lack of inflation volatility enables consumers and corporations to plan their expenditures. The level of inflation is high enough to incentivize current spending, avoid debt deflation and give central banks a cushion to lower real interest rates when necessary, but low enough to protect lenders and maintain demand.

This inflation story can be read as “a beautiful thing” just as easily as a cause for a negative Bund yield. It’s not immediately clear why the Goldilocks meme in March has given way to the deflation narrative of May and June. As Brad Tank wrote last week, the next story could be the bullish tale of the “Powell Put.”

In the end, none of these stories tells the entire tale, which is inconclusive and complex: the clash of contradictory short-, medium- and long-term signals typical of this stage of the cycle.

As investors, our job is to try to discern the narrative arc and avoid getting sucked in by the euphoric moments or dragged down during gloomy chapters. As we described in our thoughts on late-cycle investing, we think that means understanding the historical context behind the shape of modern business cycles, and observing four principles for decision-making: distinguishing signals from the noise; re-assessing strategic asset allocation to maintain true diversification; identifying through-cycle investment themes; and staying nimble enough to provide market liquidity when volatility strikes.

That is the key to surviving and thriving amid the conflicting stories of fear and greed in the late-cycle environment.