The Next Stage of the Economic Cycle  

The global economic landscape continues to evolve in ways that challenge traditional perspectives on market cycles, central bank policies, and investment strategies. In this quarter’s commentary, we explore the extended duration of U.S. business cycles, the significance of the recent 0.50% rate cut by the Federal Reserve (Fed), and the latest stimulus measures announced by the People’s Bank of China (PBOC). Additionally, we examine shifts in market performance, with a broadening of sector leadership and renewed strength in international equities. As we navigate this period of uncertainty—marked by political events like the upcoming U.S. presidential election and key fiscal challenges ahead—investors should remain selective, with a focus on long-term fundamentals rather than short-term market sentiment.

Recent Trends in U.S. Business Cycles: An Extended Perspective

The examination of U.S. business cycles reveals a remarkable evolution over the decades. Historically, economic expansions and contractions were characterized by shorter durations, often catalyzed by shocks in fiscal and monetary policies or geopolitical events. For instance, the post-World War II era experienced numerous cycles, with expansions averaging approximately five years and recessions typically spanning just under a year. The cycles leading up to the tail end of the 20^th century exemplify this trend, driven largely by abrupt shifts in monetary policy aimed at curbing inflation.

The landscape has nonetheless transformed dramatically in recent years. Modern business cycles appear to be extending beyond historical norms, a phenomenon that has broad implications for investors and can likely be attributed to a few key factors, though the list is far from exhaustive:

1. Monetary Policy Evolution: The Fed has adopted a more proactive stance in managing economic fluctuations. The recent emphasis on data-driven decision-making has allowed the Fed to implement aggressive monetary policies that can preemptively address economic slowdowns. This shift is evidenced by the rapid response during the COVID-19 pandemic, where the Fed slashed interest rates to near-zero levels and launched extensive asset purchase programs (i.e., “Quantitative Easing”). According to data from the Federal Reserve Economic Data (FRED), these interventions have significantly buoyed liquidity in the markets, contributing to prolonged economic expansions.

2. U.S. Oil Production: The surge in U.S. oil production has fundamentally altered the dynamics of the global energy market. In the past, geopolitical tensions—particularly in the Middle East—often triggered economic shocks due to oil supply disruptions. However, with the advent of shale oil extraction, the U.S. has emerged as a net oil exporter, as highlighted by the U.S. Energy Information Administration (EIA). This newfound energy independence has mitigated the impact of conflicts abroad, allowing for greater stability in global energy prices and reducing the susceptibility of the U.S. economy to external shocks.
   

3. Corporate Profitability Resilience: The composition of the S&P 500 has also evolved, with an increasing concentration in high-margin technology companies. In contrast to earlier cycles when the largest companies were more representative of the broader economy—with lower margins and higher overhead—today’s market is dominated by tech giants like Apple, Microsoft, and Alphabet. The higher margins of these companies reduce the immediacy of layoffs in response to profit fluctuations, unlike in previous cycles when declining profits would prompt swift workforce reductions along the entire supply chain, thereby accelerating recessionary pressures.

The interplay of these factors suggests a transformative period for U.S. business cycles, where extended expansions may become the new norm. Although longer expansions are generally positive for wealth accumulation, the potential downside is that they may also lead to deeper and longer recessions than what was typical in the past. The dual-edged nature of prolonged economic cycles underscores the need for vigilance and adaptability among investors as they navigate an increasingly complex economic landscape.

Current State of U.S. and Global Central Bank Policy

The recent decision by the Fed to cut interest rates by 0.50% marks a pivotal moment in the current economic cycle, signaling a shift in focus from combating inflation to addressing labor market vulnerabilities. This move, coupled with guidance for further rate cuts, suggests that the Fed is recalibrating its approach, weighing the risks of heightened inflation against the potential deterioration in the labor market. As Fed Chair Jerome Powell stated during the press conference, “As inflation has declined and the labor market has cooled, the upside risks to inflation have diminished, and the downside risks to employment have increased.”

Historically, a 0.50% rate cut is significant, particularly given the context of recent monetary policy. This level of reduction has been employed during critical economic junctures, such as in January 2001 and September 2007, when the Fed acted decisively in response to emerging economic threats. The rate cut in January 2001 was aimed at counteracting the fallout from the bursting of the dot-com bubble, while the September 2007 cut sought to address the initial impacts of the impending financial crisis. According to data from the Fed, these aggressive cuts have typically been utilized during periods of economic distress, highlighting the weight of this latest decision within the broader narrative of monetary policy history.

Transitioning to the global landscape, it is noteworthy that the Fed was one of the last major central banks to begin cutting rates. Many developed economies have already embarked on expansive monetary policies, with several countries having cut rates multiple times over the past year. This divergence underscores the varying responses of central banks to the evolving economic challenges, and uneven expansion post-pandemic, faced by different regions.

In a related development, the PBOC has recently unveiled a series of stimulus measures aimed at stabilizing the Chinese economy and financial markets. Notably, the PBOC announced cuts to key lending rates and a reduction in the reserve requirement ratio (RRR) for banks to enhance liquidity in the banking system and encourage financial institutions to increase lending to support small and medium-sized businesses.  

In tandem with these monetary measures, the Chinese government has implemented major fiscal stimulus to support the real estate and stock markets. Mortgage rates dropped by an average of 0.50%. The down-payment for second homes decreased from 25% to 15%, and developer loans and commercial bank housing delivery loans will be extended by two years. The government has also revealed a RMB800 billion liquidity support package for the stock market. All types of financial institutions will be eligible for this support, which is expected to boost sentiment in the local stock market. Essentially, this facility through the PBOC enables companies and major shareholders to borrow at very low interest rates, facilitating stock repurchases.

The initial market reactions to the actions taken by both the Fed and PBOC were both firmly positive. With the central banks and governments of the world’s two largest economies injecting significant expansionary policy changes at nearly the same time, it supports our perspective that we have officially kicked off the next phase of the global economic cycle.  

Looking Ahead: Elections, Rate Cuts, and More Volatility

As we approach the final quarter of the year, one of the prevailing topics among investors is the upcoming U.S. presidential election. Historically, elections create uncertainty, leading to heightened market volatility. For instance, during the 2016 election cycle, the S&P 500 experienced significant fluctuations in the lead-up to the results, only to stabilize shortly thereafter. However, we believe that anticipating election results or investing based on campaign promises is not a sound investment strategy. Government policy and leadership represent just one of many factors that drive asset performance. Moreover, the U.S. government system is structured in a way that is not reliant on a single leader. While a president may articulate a specific policy agenda, division within Congress often necessitates adjustments or abandonment of certain proposals. This political dynamic suggests that long-term investment strategies should be built on fundamental analysis rather than short-term political speculation.

That is not to say that the U.S. presidential election is not important. U.S. leadership and corresponding policy is immensely important over the medium to long term. In the short term, specific policies and crucial details will remain largely unclear until well into 2025 and beyond. In addition, even when policy is enacted providing clear financial tailwinds to a specific area of the economy, investment returns may not follow suit as expected given there are many other influential factors involved. Take for example, the immense amount government support provided by recent clean energy legislation during the Biden administration. The S&P Clean Energy Index is down approximately 25% over his term. Recent investments in clean energy likely fell short of expectations if government policy was the only the contributing factor in the investment decision making process.  

With that said, two areas of immediate concern for investors are the ballooning U.S. federal budget deficit and the expiration of the 2017 Tax Cuts and Jobs Act (TCJA) at the end of 2025. While the growing budget deficit seems to be a low priority issue for both candidates, the sunset of the TCJA must be addressed in short order. Given that both are related to U.S. tax revenue, addressing the TCJA will also force Congress to account for the budget deficit. While there are “permanent” provisions such as the reduction of the corporate tax rate from 35% to 21%, many of the provisions that benefited American citizens were temporary. Sunsetting provisions such as the expansion of the standard deduction and reduced federal income tax rates could further diminish disposable income nationwide. The looming readjustment of the federal estate tax exemption down from $14.3 million per individual to an estimated $7 million is also a big concern for many of our clients. Absent a complete red or blue wave, either candidate will likely need to negotiate with the other side of the aisle in what will be a watered-down version of the current tax code.  

In addition to political factors, recent announcements of significant stimulus measures from the Fed and the PBOC warrant attention. Based on stimulus announcements alone, certain sectors and industries appear to benefit more than others. In the U.S., for instance, small and mid-cap companies may see enhanced growth opportunities in a lower interest rate environment, as their access to capital improves, facilitating expansion. Similarly, international investments might benefit if the U.S. dollar weakens because of these stimulus measures. A softer dollar can enhance the competitiveness of U.S. exports and improve returns on foreign investments for U.S. investors.  

As for China, recent stimulus is viewed as more of a necessary response to their struggling economy, as opposed to the U.S., where the expansionary measures are believed to be precautionary action for a relatively strong economy. With that said, the potential benefit of such stimulus measures could extend broadly to Chinese equities given relatively low valuations following a few years of underperformance. While the long-term sustainability of the recent rally remains a question mark, investors are betting that the new fiscal and monetary policy initiatives were enough to put a floor on further downside. There are many structural and political risks that need to be considered when investing in China, but we see opportunity given that current valuations are low, and a lot of bad news is likely priced in.  

Market Leadership is Shifting

In the 1934 book “Security Analysis” by Benjamin Graham and David Dodd, the concept that market prices can dislocate from their underlying intrinsic value was born. Warren Buffet, a disciple of Graham, later went on to popularize the concept during an interview in 1973. Below is an excerpt from the book:

“In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.” – Excerpt from Security Analysis

If Graham and Dodd's notion that the market acts as a voting machine holds true, market prices are likely swayed by both reason and emotion driven by current uncertainties. Considering recent issues like the port strike, rising tensions in the Middle East, and the upcoming U.S. presidential election, it's inevitable that uncertainty and emotion will impact asset prices in the short term. Despite increased market volatility from heightened near-term uncertainties, there has been a noticeable shift in recent market trends and leadership. Throughout much of 2024, the S&P 500's gains have primarily been driven by the Magnificent 7. However, starting in August, this trend began to break, with broader participation across the equity market. Notably, this period matched with changing monetary policy expectations as rate cuts became more certain and the Fed shifted its focus from inflation to the labor market (i.e., the health of the U.S. economy).

Within the S&P 500, sector leadership not only broadened but also rotated towards the end of the third quarter. Before August, just three sectors—Technology, Communication Services, and Financials—outperformed the broad index, contributing 70% of the total return. However, August saw a shift, with 7 out of 11 sectors outperforming the index. Among those leading in August, only Communication Services maintained its position as an outperformer, while Financials and Technology fell behind.

The trend of broader performance extended beyond U.S. large-cap stocks. International equities started to outperform their domestic counterparts, partly due to relatively low valuations and a weakening dollar. In August, companies in developed international markets slightly outperformed the S&P 500, and emerging market equities more than doubled their year-to-date performance while handedly outpacing the S&P 500. This is a positive sign for investors with diversified portfolios. Although it is still early, recent cross-border price movements support our view that we are entering the next phase of the economic cycle.

The Final Stretch

As we enter the final stretch of 2024, the investment environment remains shaped by a confluence of factors, including global central bank policy changes, political uncertainty, elevated levels of global conflict, and evolving market leadership. While the global economy is bolstered by accommodative monetary and fiscal policies, risks remain, particularly as key fiscal policies come up for review in the U.S. and geopolitical tensions continue to stir. Investors would do well to focus on maintaining durable portfolios that are resilient to near-term instability, while capitalizing on opportunities presented by dislocations in value. In this complex landscape, flexibility, fundamental analysis, and vigilance are essential to achieving positive outcomes as we enter the next phase of the economic cycle.