There are many ways to measure market cycles and the business cycle, however economics is not an exact science. One of the methods that can be used alongside measuring of the yield curve is the output gap. The output gap is the difference between actual and potential economic production. It allows economists and investors to determine what point the economy is at in the business cycle. When the output is above potential, the economy starts to overheat, causing inflation. When output is below potential, the economy isn’t growing as fast as it could, possibly because of a recession. To make an analogy, think of the economy like a factory. When production gets to above capacity, quality control suffers. When production is below capacity, potential profits are squandered.
U.S. Economy Growing Above Potential
Using this understanding of the output gap, let’s look at the latest output the U.S. has experienced. In 2017 the output got higher than potential. This implies inflation is about to heat up. Higher inflation in 2018 indicates that Fed rate hikes are coming as the business cycle nears its end. There’s no guarantee this means a recession is coming in the next couple years, but it has correctly signaled one on the past few business cycles. The way the US economy could avoid a recession would be if the economy were to operate at above potential without generating inflation.
Productivity Growth Determines Economy’s Fate
Macroeconomics is far from straightforward. We’ve discussed how inflation can be suppressed by individual firms becoming more efficient as well as accepting lower margins (if these firms are big enough to affect average prices). Besides this variability and the uncertainty of how long the economy can stay above potential, there’s also uncertainty about how high the potential growth is. This is estimated based on the Congressional Budget Office’s reports. The potential can increase if productivity growth increases. This is why productivity growth is the best lever to pull to increase long term economic growth. The disappointing productivity growth in 2016 hurt the economy’s potential. 2017 saw a moderate pickup in productivity growth. In Q3 2017, productivity growth was up 1.5% year over year. From 1875-1975 productivity growth was 2.4%, but from 1975-2015, it was only 1.2%. If productivity growth picks up in 2018, this could delay the next recession.
Business Cycle In Tune With Output Gap
The output gap is used to time the business cycle, so it’s interesting to see how it compares to other predictions for the cycle. Morgan Stanley sees the economy going from a Goldilocks scenario to one of excess demand. This is in tune with the economy growing above its potential. It shows that this means growth will peak, inflation will rise above targets, the Fed will hike rates and unwind its balance sheet, bonds will sell off, and junk bonds will sell off relative to treasuries. The next step is a recession. The critical determination investors must make is how long the excess demand period will last. Even though growth peaks, it doesn’t mean stocks will peak. Stocks can rally the most at the end of the cycle.
Add the output gap to the list of indicators you look at to time the economy. Another indicator to examine is the yield curve as we mentioned earlier which can not only help you with timing, but also demonstrate the best cyclical assets to rotate to during various phases of the market cycle. The next few years are critical because we’re about to be in the longest expansion in modern history. Eventually it will end. In that event, you must prepare your portfolio so you don’t feel the brunt of the selloff as the euphoria turns to fear.
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