We’re At the End Of The Current Economic Cycle - Get Ready For A Wild Ride

April 5, 2018

We’re At the End Of The Current Economic Cycle – Get Ready For A Wild Ride

Yesterday, we discussed what’s going on with stocks. One of the explanations is that the market is pricing in the end of the economic cycle. If that’s true, there is a lot more downside for stocks.

Let’s see what the latest economic news is, how that fits the economic cycle, what the probability for a recession is, and what we should expect from stocks.

Economic News

The economic news is relatively good. Jobless claims have reached the lowest level in history.

Figure 1: Jobless claims. Source: Wall Street Journal.

The unemployment rate is expected to fall even further which means more jobs and an even stronger economy.

Figure 2: Unemployment rate. Source: FRED.

And inflation is slowly reaching the FED’s target of 2% which shows healthy demand for goods and services.

Figure 3: U.S. core inflation. Source: FRED.

To sum it all up, even the FED has increased their economic growth projections. Things haven’t been this good in the past 8 years, so why are stocks declining and why are the markets so nervous?

Well, those who have a longer term perspective on things—and by longer term, I mean a cyclical perspective on things—know that the economy, all economies for that matter, work in cycles and after 8 years of economic growth, it’s a good time for a quick consolidation and recession which is always painful, for stocks, people, and especially the business environment. Let’s see where we are in the cycle.

The Economic Cycle

There are three major components of economic growth: productivity, the short term debt cycle, and the long term debt cycle. Today, I’ll focus on the short term debt cycle first, and mention the long term as well to show what can happen. We’ll touch on productivity some other time as credit is the most important thing now.

An economy is driven by credit. The more credit there is, the bigger the growth is as consumers spend more. So, let’s take a look at consumer credit.

Figure 4: U.S. consumer credit has exploded in the last 10 years. Source: FRED.

So, consumers have 45% more debt than they did in September of 2008. Did we see that correctly, 45% more than in 2008?!?

From an economic perspective, such a situation is unsustainable because wages haven’t grown 45% over the past 10 years and as we have seen in the unemployment chart, the current unemployment level isn’t far from what it was in 2008. This means the following:

  • At some point people will reach their credit maximum.
  • Higher interest rates will increase debt payments and defaults.
  • Demand for cars, trips, pools, and houses will drop.
  • A recession is inevitable, the question is when.

A recession is inevitable and the only question is when because as soon as that credit growth continues to grow, things will look good but we all know that kind of growth is unsustainable and it was all thanks to lower interest rates which have been declining since 1982. If we take a look at consumer credit in the last 50 years, we can see that it has spiked since interest rates have been declining.

Figure 5: Long term consumer credit. Source: FRED.

The good scenario is one where the next recession is just a slowdown and a short term credit cycle where things continue as they have been over the last 50 years. The bad scenario is one where we are at the end of the long term credit cycle, which is usually one that lasts around 75 years, where we’ll see a 1930s scenario take place.

What Does This Mean For Stocks?

A short term debt cycle recession would eradicate the weeds from the stock market, readjust valuations on good business, and offer plenty of buying opportunities.

If the long term debt cycle bursts, we are in for a complete change on how things work and how things have worked over the past 75 years. Instead of the constant debt growth that has been going on over the last 75 years, we would see painful deleveraging, probably inflation as governments would rush to print even more money, and stagflation. One chart will explain what I mean.

Figure 6: Projections for interest rate costs for the federal government. Source: Wall Street Journal.

So if interest rates go up, the interest on the huge pile of U.S. debt would rise to unsustainable levels. The Wall Street Journal projects that more than 20% of the federal revenue will have to be used for interest payments in 10 years, this is huge when compared to the current 7%.

We’re in for a wild ride over the next few decades and that is how you have to position yourself if you want to get ahead.

If you invest in growth stocks, find those that will grow no matter what happens in the cycle thanks to the great disruptive businesses they have. If you want protection, find stocks that represent hard assets where the value of the currency doesn’t matter. And if you want hedges, find those that best suit your portfolio, from fixed interest mortgages to precious metals.