U.S. Economy Continues Slow Burn

12/19/2016


We're in the midst of the fourth-longest expansionary period since the 1850s. The U.S. is 90 months removed from its last economic trough, which occurred in June 2009, according to the National Bureau of Economic Research. Since 1960, three of the previous seven expansionary cycles exceeded 90 months.

Plotting our location in the business cycle, described at the far right, can help investors gauge whether the current upswing may last another few months or another few years.

Based on the body of evidence, the U.S. appears to be in the late-upswing phase of the business cycle, though not all arrows point in the same direction. Key economic indicators, illustrated in the chart below, show that inflation has risen in the past few months but remains modest, consumer sentiment is improving, and the unemployment rate stands at its lowest level since August 2007. However, the late-upswing phase also usually exhibits restrictive monetary policy to combat an overheated economy, a scenario that still seems pretty far away.  

Stock performance during the late-upswing phase tends to be mixed. Corporate earnings are often pressured by rising input costs and slower sales growth.

Beyond the business cycle, other factors play a crucial role in assessing the stock market's capacity to climb higher. The S&P 500 Index has returned 12.5% including dividends so far in 2016, putting it on pace to deliver a double-digit annual gain for the sixth time in the past eight years. That extended rally leaves stocks looking somewhat expensive and investor sentiment fairly bullish, though neither trend seems extreme.

The average stock in the S&P 500 Index trades at 22.3 times trailing earnings, above its 20-year average of 21.0. The index's average trailing P/E has exceeded its current level in 27% of months over the past 20 years. Bullish sentiment among small investors holds at 43%, according to the American Association of Individual Investors, above its long-term average of 38.5%.

In hindsight, factors contributing to the current elongated upswing seem obvious. After all, the last recession marked the worst downturn since World War II, and the immediate recovery was historically sluggish, preventing the market from getting overheated. Even a modest dose of fiscal stimulus, combined with lower corporate tax rates, could help keep the U.S. economy humming along.


Five phases of the business cycle

1. Initial recovery — Governments launch stimulus policies, Treasury-bond yields decline, and stocks surge as concerns about a longer recession ease. Riskier investments tend to outperform. This phase typically lasts a few months.

Sectors to target: consumer discretionary, financials, industrials, materials, technology.

2. Early upswing — Confidence rises, unemployment begins to fall, inventories build, and profit margins improve. Short-term interest rates rise as stimulus policies unwind. Inflation stays low. This phase tends to last at least one year — or several years amid soft growth.

Sectors to target: industrials, technology.

3. Late upswing — Confidence is high, unemployment low. As inflation rises, the economy risks overheating. Stocks usually extend gains but can be volatile.

Sectors to target: consumer staples, energy, health care, utilities.

4. Slowdown — Economic growth slows, confidence wavers, interest rates rise, inventories are slashed, and short-term interest rates peak. Interest-sensitive stocks may outperform. Slowdowns typically last a few months to a couple years.

Sectors to target: financials, materials, utilities.

5. Recession — Defined as two straight quarters of lower gross domestic product. Consumer spending plunges, unemployment rises, and inflation falls. Recessions tend to last six months to one year.

Sectors to target: staples, health care, telecom, utilities.

Sources: CFA Institute, Fidelity.


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