Relax, it’s just a mid-cycle expansion

The market adopted a risk-off tone when headline Q1 GDP came in lower than expected at 1.6%, compared to an expected 2.5%. More importantly, core PCE rose at an annualized rate of 3.4%, which was hotter than expectations and led to stagflation fears. Upon closer inspection, nominal GDP growth was dragged down by the combination of inventory adjustments and exports. Final sales, which is a better signal of economic growth, came in at 3.1%.

Greg Ip at the WSJ offered a constructive interpretation when he pointed out that the U.S. economy still accounts for 26.7% of global GDP, which is the highest level since 2006.

 

Investors should fade stagflation fears and embrace the “no landing” scenario. These conditions should be good news for risk assets. It’s what a mid-cycle expansion looks like.

Instead of focusing on economic statistics, consider the message from the financial markets. Investors are seeing the combination of strong stock and commodity markets and a weak bond market.
 

 

This idealized depiction of a business cycle would classify the current phase as a “stage 4” market. I interpret this as a mid-cycle expansion when the economy is enjoying bullish fundamental and technical momentum.
 

 

Here is an example of fundamental momentum. The recent market correction on a peak-to-trough basis was -5.5% for the S&P 500. Investors should consider this episode as a buying opportunity as the price decline was attributed entirely to P/E contraction. Forward 12-month EPS estimates are continuing to rise.
 

 

The economy is healthy. One of the key earnings reports that I monitor is the VISA double beat on both sales and earnings as the company reported “resilient consumer spending”. Moreover, fundamental momentum is expected to broaden. Earnings growth for the non-megacap Big Tech companies are forecast to outpace Big Tech by year-end.
 

 

From a technical perspective, the positive readings from the monthly MACD histogram of the NYSE Composite underline the strength of the equity bull phase. Historically, positive MACD crossovers have signaled momentum-driven bull markets that have been long lasting.
 

 

Friday’s March PCE report didn’t really move the needle of expectations in the wake of Thursday’s GDP report. The market is now only discounting a single rate cut in 2024, which is expected to occur at the September FOMC meeting.

Putting all together, stock prices should continue to advance during a mid-cycle expansion, even in the absence of rate cuts. As long the economy remains resilient, earnings continue to rise, and we don’t get a significant acceleration in inflation, the bull market will continue.
 

 

Despite all the hand wringing over the last-mile inflation problem, my base case calls for continued progress toward the Fed’s 2% inflation objective. One of the most troublesome elements of inflation is shelter, and it is well known that Owners’ Equivalent Rent is a lagging indicator of shelter inflation. The Cleveland Fed’s New Tenant Repeat Rent Index (blue line) shows that rent growth has slowed to well below 2%.

 

 

Beware of accidents

That said, there is theory and there is practice. While the idealized version of the economic cycle is a useful analytical framework, the past history of 20 years shows that similar episodes of “strong stocks, strong commodities, and weak bonds” have resolved in mid-cycle accidents (red circles) whose causes were often independent of the economic cycle.
 

 

 

Tail risk: Asian competitive devaluation

The most obvious spark is the tail-risk of an Asian competitive devaluation. Starting in Japan, the USDJPY exchange rate has been weakening, which was exacerbated by last week’s lack of action by the BoJ. Yen weakness has occurred despite a rise in the 10-year JGB yield owing to a widening spread between the Treasury-JGB that’s attracting Japanese investors abroad.
 

 

The pressures that yen weakness is putting on China and the effects of PBOC intervention are becoming more evident. In the last month, the onshore yuan (white line) has been weakening while the offshore yuan (blue line) has been roughly flat, but in a choppy manner. This pattern may be a sign that the PBOC is leaning against the market to avoid yuan weakness. The risk is a sudden and wholesale devaluation of the Chinese yuan, which would reverberate all over Asia.
 

 

Brad Setser at the Council on Foreign Relations also found that the onshore yuan has been bumping against the lower end of its policy band, which is another sign of downward pressure.
 

 

Another sign of downward pressure on the Chinese yuan from capital flight is the stampede by Chinese investors into gold.
 

 

The risk, therefore, isn’t just Japanese yen weakness, but yen weakness that pressures China to devalue the Chinese yuan in one sudden stroke. Such a shock would trigger an emerging market stampede of competitive devaluation and spark a risk-off tone to financial markets.

As an aside, Callum Thomas of Topdown Charts offered the following analog of the gold price when compared to the Chinese stock bubble of 2014–2015. Gold prices could explode upward should China decide to suddenly devalue the yuan.
 

 

In conclusion, the U.S. economy is undergoing a mid-cycle expansion, which is characterized by a combination of fundamental and technical momentum. As long as the economy stays resilient, earnings estimates rise and inflation doesn’t accelerate, stock prices can advance without rate cuts. The risk of a cyclical bear that begins at these levels is minimal.

The key tail-risk to the benign scenario is a disorderly Asian competitive currency devaluation that sinks emerging markets and sparks a risk-off environment, which would be equity bearish.