Economic Commentary -- February 2012

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

The Business Cycle: Dead or Alive?
Twelve years ago, the President’s Council of Economic Advisers questioned whether the concept of the business cycle in the United States economy was valid, given the robust and long-lasting economic boom of the 1990s:

“Although the business cycle has been a recurring feature of the U.S. economy for as far back as we have reliable data, some observers have argued that the economy in the 1990s has fundamentally changed and that the concept of the traditional business cycle is outdated.”

Economic Report of the President, 2000, p. 74

“Of course, it is premature to declare the business cycle dead. But there are reasons to believe that the economy will continue to perform as well as, if not better than, it had in the recent past, with less of the roller-coaster ride that characterized the 1970s and early 1980s (not to mention earlier decades).”

Economic Report of the President, 2000, p. 79

Not so fast. Just a little over a month after that optimistic report was issued, the Dow Jones Industrial Average hit its internet bubble high and began to fall. In the 12 years since this report was issued, it’s been evident that the business cycle is indeed alive and well in the U.S. economy. In fact, the question now is not whether the business cycle exists, but how long it is – and whether the duration of the business cycle is contracting.

The business cycle is a cornerstone of how economists view the functioning of the economy and how the central bank and government policymakers respond to the economy. This month, we take an in-depth look at the business cycle, including the nature and history of the business cycle in the U.S., how the business cycle has changed and the future implications of a potentially shorter business cycle.

Business Cycle Overview
It seems like the business cycle has always been with us, but in fact, the concept was first codified in the U.S. in 1913 by Wesley Mitchell’s Business Cycles. (He later co-authored Measuring Business Cycles with A.F. Burns in 1946.) Mitchell conceptualized the idea that economic indicators move together and can be used to determine whether an economy is growing or shrinking and where that economy may be headed in the future.

The business cycle rotates between economic expansion and contraction, factors typically measured by a country’s gross domestic product (GDP). In an expansion, overall economic output increases, employment rises and new construction increases. Inflation may also rise, especially if the economy expands quickly. Conversely, in a contraction, economic output decreases, unemployment rises and new construction declines. Inflation usually slows during recessions as well. Expansions and contractions are frequently divided into “early” and “late,” but for now we’ll focus only on the broad definition.

Mitchell and Burns defined a recession as a sustained period of time when a broad range of economic indicators falls. Conversely, an economic expansion or recovery occurs when those same indicators turn and stay positive for a sustained period of time. The National Bureau of Economic Research (NBER), an independent economic research board, tracks the peaks and valleys of U.S. business cycles and has undertaken the job of labeling recessions and recoveries.

The key challenge for economists, policymakers and investors lies in the fact that, unlike other cycles, business cycles are not regular or predictable. In Mitchell and Burns’ words:

To say that business cycles are departures from and returns toward a normal state of trade or a position of equilibrium, or that they are movements resulting from discrepancies between market and natural rates of interest, will not help, because we cannot observe normal states of trade, equilibrium positions or natural interest rates.

While economists and investors use economic data points to gauge the economy’s direction, it’s not a definitive process. While different indicators measure different parts of the economy, more importantly, indicators are subject to interpretation, or more often than not, misinterpretation.

Although recessions and expansions come in all shapes and sizes – both in magnitude and duration – each shares certain characteristics. In a recession, employment, income, sales and output tend to decline in sync, although not necessarily to the same degree. In an economic expansion, the opposite occurs: output, income, sales and employment all increase and those factors feed on each other, creating more of each as the economy recovers.

Leading Economic Indicators and the Business Cycle
The index of Leading Economic Indicators (LEIs) is widely used by economists and strategists to define the trend in the business cycle. Interpreting the direction and the signal of LEIs is important in gauging where the economy is at a given time and where it might be headed. LEIs typically turn positive between the early and late phases of an expansion. As figure three illustrates, LEIs typically turn positive while still in the midst of a recessionary period. Likewise, the indicators often turn negative prior to the recessionary period as defined by NBER.

While each part of an expansion and recession lasts less than 12 months, it takes nearly 50 months, on average, to complete a cycle because the economy doesn’t move smoothly from late expansion to early contraction. Instead, it moves back and forth between those two stages before settling into a full-blown recession. Usually, the economy spends most of those nearly 50 months in two of the four stages: growing moderately or better in the late expansionary stage and growing slowly in the early contraction phase.

Shorter Business Cycles on the Way?
Recently, we’ve experienced some of the longest recoveries and deepest recessions in decades. The economic expansion of the 1990s began after a fairly mild recession in 1991 and lasted until 2001, one of the longest periods of economic expansion in recent history. The Great Recession of 2007-2009 was the most severe economic recession since the Great Depression of the 1930s. And the U.S. economy, during the decade of 2000-2010, experienced far more economic turmoil than in the two previous decades combined. Isn’t this evidence of longer cycles?

Proponents of the shorter business cycle theory argue that the longer expansions that occurred in the 1980s and 1990s were the exception. They were sparked by a 30-year secular global decline in inflation and interest rates rather than the factors that generally spark economic expansions (increases in employment, income, sales and output). Because inflation trended lower, governments and central banks were able to intervene in a recession via fiscal and monetary stimulus without immediate adverse consequences.

Prior to this 30-year period, extended periods of low interest rates led to increased inflation. This didn’t occur during the 1980s and 1990s. However, low interest rates and low inflation did lead consumers, businesses and sovereign nations to take on too much debt because it was cheap. Thus, politicians and central bankers grew overconfident in their ability to manage the business cycle. While the traditional remedies of fiscal and monetary stimulus worked during the 1980s and 1990s to bring developed economies out of a recession, they haven’t been effective in stimulating economies in the wake of the Great Recession.

Going forward, traditional remedies may not help economies avoid recessions. Because governments are maxed out in leverage (the amount of debt they issue), they aren’t able to provide fiscal stimulus at precisely the time that it would help these economies either stay in recovery or move out of recession. Instead, austerity is the word of the day – or perhaps decade.

Some advocates of shorter cycles believe the U.S. will follow Europe into a recession at some point this year. According to Deutsche Bank’s Long Term Asset Return Study by Jim Reid, the average length of the 33 expansions in the U.S. economy presages that the U.S. will enter a recession by August of this year at the latest. Even if a recession doesn’t happen this year, any continued growth is likely to be low or sluggish.

The Role of Inflation
Because the Fed has used all of the tools at its disposal to drive interest rates down with the intent of stimulating the economy, some researchers instead argue that inflation is the more powerful force driving or explaining leading economic indicators. As long as inflation stays low, it’s more likely that the economy will avoid a recession. If inflation picks up, there’s a greater chance that the economy could fall back into recession.

The variability of inflation is driven primarily by changes in commodity prices, particularly oil. Oil prices are volatile and are likely to impact the direction of the economy going forward. When oil prices are higher, developed economies tend to retreat, and when oil prices are lower, they tend to grow. This is because when consumers and businesses have to spend more money on gas and oil, they have less to spend elsewhere. When oil prices are lower, they can spend more on discretionary purchases that drive economic growth.

What to Watch For
There is some evidence to support the contention that the business cycle is getting shorter, which could lead to continued volatility in the markets. However, despite the day-to-day volatility in the markets and the incessant worry over the situation in Europe during the fourth quarter, equity markets actually gained a foothold and ended up positive for the year. You wouldn’t know that from the CNBC commentators or the headlines in The Wall Street Journal, however.

We expect continued uncertainty on the macroeconomic level. Central banks are out of ammunition to spark a recovery, consumers continue to deleverage, downward pressure is exerted on sovereign debt credit ratings, and slowdowns in emerging market growth occur amid global markets that are increasingly integrated. Other events such as the earthquake in Japan early last year and, more recently, the flooding in Thailand have demonstrated that natural disasters can impact the global supply chain. That in turn can lead to shorter expansions and longer contractions.

To gain some visibility regarding the direction the economy is headed, keep an eye on Leading Economic Indicators and the Institute for Supply Management (ISM) Manufacturing Index, both of which have been trending positive. The ISM Manufacturing Index increased in October and November. In the past, positive and improving measurements in the ISM have been associated with strong stock market performance. If these indicators continue to gain ground, it’s likely the recovery will hold. If not, we may enter another recession later this year.

Where We Are Headed
The business cycle is important to investing because the stock market can be seen as a leading indicator of the economy, as the market often anticipates the future economic state. Economic progress in the U.S. is expected to be moderate but unspectacular this year. Leading indicators are pointing this way, but if we are in an era of shorter business cycles, the indicators can change rather quickly.

Some will argue that knowing exactly where we are in the business cycle can be beneficial for adjusting portfolio allocations. Perhaps, but this assumes an investor knows exactly where this point is. Shorter cycles will probably make it even more challenging to correctly identify the current stage of the cycle.

If we are entering an era of shorter cycles, we would expect greater volatility. This can cause even more angst for investors without a well-crafted long-term investment policy. We have continuously and consistently expressed our view that market timing doesn’t work for the average investor. The way we see it, shorter cycles would simply provide more opportunities to get whipsawed – that is, to be on the wrong side of the market after reacting to it. Diversification and guidance from your financial representative remain critical tools for dealing with whatever the business cycle presents to us.

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics, and news.

The Dow Jones Industrial Average Index® is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.

The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.

The National Bureau of Economic Research (NBER) is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is well known for providing start and end dates for recessions in the United States.

Deutsche Bank AG is a global banking and financial services company with its headquarters in Frankfurt, Germany. In its Long Term Asset Return Study, Jim Reid analyzed the average length of the 33 U.S. expansions since 1854.

The monthly index of Leading Economic Indicators is maintained by The Conference Board, a private research group. It determines the value of the index from the values of 10 key variables which have historically turned downward before a recession and upward before an expansion. In order to increase the relevance of the index, The Conference Board is revising the index for the first time since 1996. New data points designed to improve the index include a Conference Board consumer confidence poll, a Conference Board Leading Credit Index, the Institute of Supply Management’s New Orders Index and new orders for non-defense capital goods.

The Institute for Supply Management is a not-for-profit U.S. association for the benefit of the purchasing and supply management profession, particularly in the areas of education and research. The ISM Manufacturing Index tracks the amount of manufacturing activity that occurred in the previous month.

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