IMF Article IV consultation documents are generally only of interest to economists and investors at the geeky end of the spectrum. However, last week’s US Article IV document generated a few headlines in the global media. Most of the column inches were dedicated to the supra-national body having nudged down their economic growth forecasts for this year and next – a reversal of their earlier upgrade reflecting uncertainty over how much demand-side stimulus President Trump will be able to get enacted. Yet for us, this was not the most interesting aspect of the report.
According to the latest projections, the IMF expects the US economy to expand 2.1%, 2.1% and 1.9% over the next three years. Hardly earth shattering numbers one may think, and indeed they are not far away from most estimates of US trend growth (the favourite forecasting method of economists), but they need to be put into context to comprehend their significance.
Implicit in the term business cycle, jargon every economics student is taught to describe the fluctuations in aggregate demand, is the subtle suggestion that economic activity plots out a sinusoidal-like wave of expansion and contraction. Unfortunately, reality is far more complex.
According to the NBER business cycle dating committee, since 1854 there have been 33 business cycles in the US economy. On average, expansions (trough to peak) last 38.7 months, while the average contraction (peak to trough) is 17.5 months long. However, as is often the case with averages, they mask considerable variability. The shortest expansion occurred in 1920-21 and lasted a mere 10 months whereas the longest expansion occurred between 1991 and 2001 (a total of 120 months).
The current US economic expansion, which the NBER estimates began in June 2009, has just celebrated its eighth birthday. At 96 months young, this is much longer than the average expansion witnessed over the past 160 years and, even in the post-war period where expansions have been more durable, it exceeds the average by over three years.
As the Article IV document noted, this isn’t unchartered territory. Two expansions in the post-war period made it into triple digits, February 1961-December 1969 (106 months) and, as already mentioned, March 1991-March 2001. But, if the IMF is correct, the current US economic expansion will be a record-breaker – the longest in over 160 years! Quite a bold call really.
The IMF’s Poor Track Record
Admittedly, the IMF’s track record on predicting expansion-ending recessions is, like the broader economics profession, rather poor as evidenced by the fact that they completely missed the Great Recession – the worst in the post-war period. That said, in their favour is the fact that the current economic expansion is extremely unusual.
After eight years of recovery one would normally expect a building up of inflation pressures due to the eradication of spare capacity. Yet, much to the surprise of central bankers – both in the US and abroad – and investors, inflation pressures have been relatively mute and, judging by the evolution of public perceptions of future inflation, will remain so for some time. This absence of inflationary pressures is important because as Rudi Dornbush, who co-authored a popular undergraduate economics textbook with current Fed Vice Chair Stanley Fischer, famously quipped;
“None of the postwar expansions died of old age, they were all murdered by the Fed”.
During the Volker era (Fed Chairman 1979-87) such sentiments were not entirely misplaced. In fact, it is not hyperbole to say the 1980/81 US recessions were deliberately induced by the Fed aggressively tightening monetary policy in order to break the back of the escalating wage-price spiral set in motion by earlier the OPEC-induced oil price spike.
A Man-made Recession
However, since Volker, the charge of murder should probably be transmuted to involuntary manslaughter because of the lack of premeditation on the part of central bankers – recessions are now viewed as negative economic outcomes that should be minimized, if not avoided altogether. Despite all the chatter about increased hawkishness, there is nothing in the recent slew of statements from various central bankers to suggest their reaction function has radically changed. Fed, ECB and BoE officials have all flagged the prospect of less monetary accommodation, but none of them envisage policy changes of a magnitude that is likely to result in recession.
Nonetheless, these comments come at an interesting time because, as outlined in the last Market Insight, there is unusual divergence in crowd thinking on US economic growth. In mainstream media, sentiment towards the US economy has been steadily declining over recent months and has just dipped into negative territory (not necessarily a recession warning but heading in that direction). By contrast, social media sentiment is significantly more positive, even after the recent pullback.
Economic Growth Sentiment By Media Type – US
As Trump is the first (and loudest) to claim, mainstream media coverage of him and his administration has been negatively biased, which could well account for this unusual divergence. However, the tonal difference in crowd thinking towards economic growth between the media types is not exclusive to the US. It is common across all the major economies as can be seen in the following exhibits.
Global Economic Growth Sentiment – Mainstream Media
Global Economic Growth Sentiment – Social Media
For some reason, mainstream media is consistently more pessimistic about global economic growth than social media. Does this divergence reflect the fact that professional investors, pondering the reduction in the term premium in US Treasuries seen over the past several months and/or contemplating the merits of staying long US equities when valuations are historically rich, are – with one eye on economic history – increasingly worried about the longevity of the economic expansion?
This would certainly explain the sensitivity to the recent central bank verbiage. By contrast, social media, which is considered more reflective of the thinking of Joe Public (less well versed in the activity of the NBER’s business cycle dating committee), simply reflects what people are seeing and feeling in their everyday lives.
Previously, at the aggregate level, economic conditions appear favourable –growth is “neither too hot nor too cold but just right” and inflation pressures are moderate. This suggests a benign environment for risk assets. However, underneath this aggregate, there is tension as a consequence of this polarization of views. How this tension is resolved will set the tone for global financial markets over the coming weeks and months, if not quarters.
Near-term there is a risk that the negativity in the mainstream media filters through into the broader general public, especially as crowd sentiment in social media is at its highest levels since 2010 in many leading economies (and hence is in some sense extreme). Indeed, social media sentiment has pulled back slightly and the recent weakness in global risk markets could develop into what was previously labelled an “ursa minor” event.
Recession is Unlikely
That said, there are two key reasons why the bears who believe that the unpleasant aftermath of the greatest monetary policy experiment in history is unfolding and this is the start of a Great Depression II are wrong.
First, there is scant evidence of irrational exuberance in the crowd-sourced sentiment indicators. One of the most important aspects of a bubble – aside from prices being fundamentally overvalued – is that the majority of market participants are oblivious to being inside the bubble, rather sentiment surges as the crowd is swept up by enthusiasm.
Does that feel like the current situation? This is unlikely. There are simply too many worries and concerns about asset price bubbles being expressed, which get reflected in our sentiment indicators – see exhibit below. Sure, an Ursa Major market event in real, if not nominal, terms could unfold at some point in the future, but it would almost certainly require uniform buy-in to the bullish case and the conditions are not yet ripe. The same conclusion applies to technology stocks and the crypto-currency Bitcoin, whose recent price declines have encouraged similar speculations.
Global Equity Sentiment – Mainstream And Social Media
Earlier this week Fed Chair Yellen predicted that there would not be another financial crisis in our lifetime. Like many others no doubt, this was difficult to swallow –a tangible whiff of hubris – and admittedly she is 70 and hence her time horizon might be shorter than most investors. Yellen may be too confident, but the simple fact is central bankers are not as policy-impotent as many commentators would like everyone to believe. This is our second reason for disagreeing with the “uber bearish” scenario – it ignores the potential for a major global policy response to avoid a toxic global macroeconomic outcome occurring.
Fighting off the Bears
If removing monetary policy accommodation, as they seem intent to do, leads to a significant mark-down in global asset prices central bankers can promptly reverse direction. They are not out of bullets – they still have stimulus options. And, be in no doubt Yellen and her central banker colleagues around the world will do everything they can to avoid the bears just as the family featured in the children’s story (Spoiler alert: They run swiftly in the opposite direction).
For these reasons, any near-term weakness in asset prices must be seen not as the start of a major bear market move, but more likely a classic “bear trap”. And, if you want to see what they look like check out the NASDAQ circa 1998 or Chinese stocks circa 2015 – see below.
Crowd-Sourced Sentiment – Chinese Equities