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U.S. Outlook: Late Business Cycle Blues

Amid signs that the long expansion has begun to fade, Morgan Stanley’s economists and strategists size up prospects for growth, monetary policy, equity markets and more.

In the age of extreme weather, policy and politics, there is still the business cycle. For the current U.S. expansion, one of the longest on record, time may be running out.

“We believe there are enough signs to suggest the U.S. economy has moved into the late phase of its business expansion,” says Ellen Zentner, Morgan Stanley’s chief U.S. economist. Corporate earnings are under pressure; businesses are cutting spending; job growth has slowed; corporate defaults are rising, and cracks have emerged in some areas of consumer credit. Meanwhile, global headwinds, such as Brexit, are also taking a toll.

As a result, Zentner, who was the only major Wall Street economist to call the Federal Reserve’s decision to raise its key interest rate in December of last year, and originally expected an additional increase late in 2016, now expects the Fed to take no action this year—or next. Given more accommodative monetary policy, Zentner maintains her forecast for 1.7% annual growth this year, but believes the economy will slow to a 1.5% annual growth rate in 2017. She also cautions that the risks to this outlook are skewed to the downside, with a higher probability of recession (40%) occurring in the next 12 months.

How should investors react? All things being equal, “the U.S. remains the best house on the block,” says Adam Parker, chief U.S. strategist. Given global headwinds and uncertainty elsewhere, many investors continue to rely on the relative stability and high quality of U.S. equities.

What began as a concentrated pullback in energy-related sectors, following the collapse in oil prices, has now spread more broadly and has garnered increased attention from monetary policy makers.

Caution in Transit

Indeed, when it comes business cycles, "late" doesn’t have to be a dirty word, Zentner says. “It’s an important phase that can last anywhere from several months to several years, and is marked more generally by slower growth.”

The transition can be subtle. Household balance sheets, for example, are still healthy historically, with high liquidity, low levels of obligations and low interest expense. Yet, “we see evidence that the peak of health has likely passed—at least in certain segments of consumer credit,” Zentner says, such as auto loans, where default rates have increased. And pockets of strength persist. The U.S. housing market, for one, shows no signs of late cycle overheating. Inventory constraints haven’t eased as much as expected and, thus, continue to support annual home price growth of around 5% to 6%.

As a whole, however, the economy is less resilient to shocks late in the business cycle. “Financial conditions remain in a state of flux, with a drop in bond yields providing substantial cushion against tightening, as investors responded to Brexit by marking down expectations for the future path of the federal funds rate,” Zentner says. “In this environment, potential changes in the economic outlook are subject to a wide range of uncertainty.” 

Knock-On Effects

Business investment seemed to have declined in the second quarter, marking the third straight quarterly decrease. “A string that's hard to find outside of recessions,” Zentner notes. “What began as a concentrated pullback in energy-related sectors, following the collapse in oil prices, has now spread more broadly and has garnered increased attention from monetary policy makers.”

The dollar’s continued strength has also hurt demand for U.S. manufactured goods. In a global economy fraught with prolonged uncertainty, demand for U.S. exports is likely to remain depressed, and businesses may respond by delaying or scrapping hiring decisions. “We believe we have already begun to see a slowdown in new hiring following declining profits and investment,” Zentner says. She expects an unemployment rate of 4.8% by year-end, where it stays throughout 2017. At that level, wages should continue to grow, providing many households with a measure of financial progress.

Meanwhile, Parker’s advice to investors: Keep overweight on utilities and healthcare, underweight on materials, technology and consumer staples, with preference for high-quality, large capitalization stocks, but balanced on growth vs. value.

For more Morgan Stanley Research on the U.S. economic and strategy outlook, ask your Morgan Stanley representative or Financial Advisor for the full reports, “US Economic Summer Outlook: Late Cycle Woes” (Jul 17, 2016) and “Global Strategy Summer Outlook: Dealing with Disappointment” (Jul 17, 2016). Plus, more Ideas.

*Ellen Zentner is an economist and is not expressing recommendations on any securities.