In May of this year, our current period of economic expansion will be the second longest expansion since 1945. At 104 consecutive months without a contraction, the current expansion is the third longest out of 11 economic expansions since 1945. The longest expansion in recorded economic history lasted for 120 consecutive months, from 1991 to 2001.
The Federal Funds interest rate is on a painfully slow upward trajectory, with 3 rate hikes expected this year. However, interest rates are still very low in historical terms. After a decade of ultra-low interest rates, the valuation of the stock market has exploded, savings are perilously low, and yields on 10 year bonds are expected to surpass 3% for the first time since 2013.
We are becoming perilously close to the peak of this growth cycle, and a seemingly over-inflated stock market seems perfectly consistent with signs of slowing economic momentum. The big question now is—will the market cool, or will the market collapse? And, if a market correction is imminent, how soon can we expect it?
Savings
When the economy is overheating, households reduce their savings and increase their use of revolving credit. Right now, U.S. personal savings stand at just 3.2% of disposable income, suggesting that the U.S. economy is nearing the end of its boom cycle. Revolving credit use also suggests that we are in the late stage of economic expansion. Lower savings rates translates into reduced long-term investment. The last time savings rates were below 4% for a prolonged period of time was from 2005 to 2008 in the run-up to the Great Recession.
Household Debt
The Federal Reserve Bank of New York released its Household Debt and Credit Report in February. The report revealed that total household debt, including mortgage, auto, and student debt reached a new peak in the final quarter of 2017, rising $200 Billion to reach a new high of $13.15 Trillion. The report revealed that mortgage debt rose 1.5%, auto loans by 0.8%, and 2.5% on student loan debt. What is perhaps most striking is that 71% of total household debt is “housing debt”, a ratio that is very close to the pre-recession peak of around 73% during the height of the sub-prime mortgage crisis.
Oil Price and Full Employment
Portfolio Manager and Bloomberg economist Conor Sen wrote last year about the relationship between full-employment, oil price spikes, and a looming recession. This theory is based on historical patterns in the US economy; every time full-employment is reached, an oil price spike is almost always experienced in the preceding years. This is an important economic relationship because 10 out of the last 11 recessions were associated with oil price spikes. As existing literature demonstrates, oil shocks have significant negative effects on GDP growth rates. The price of Crude Oil Brent (ICE) has risen significantly since June last year from $44 a barrel to around $62 a barrel today. This is lower that the January high of $70, but I expect this trajectory to continue—we could see $80 a barrel this summer.
In terms of full-employment, there have been various periods of full-employment during intervals of stable economic growth in the past. Since 1950 there have been 5 such periods whereby the rate of unemployment remained at or below 5% for 12 months or longer. The last time this occurred was from 2005 to 2008, when full-employment lasted for 33 months, before that was 1997 to 2001, lasting 53 months. The average period of sustained full-employment since 1950 is just under 40 months. Considering that full-employment was reached in August 2015, we still have some leeway, although based on historical patterns of full-employment and economic recessions, it is highly likely that we will experience a market correction in the coming 18 months.
Another indicator of a market nearing the end of an expansion is an increasingly tight labor market. The unemployment rate has been below the natural rate of unemployment (NAIRU) for almost a year now. The trend is unsustainable by definition, and can lead to a spike in wage and price inflation. This is consistent with pre-recession behavior for unemployment trends in past business cycles.
The lowdown
Ultra-low interest rates over a prolonged period of time have fueled a stock market bubble, discouraged household saving, and inflated household debt through easy access to credit. The question now is—how well prepared is the Federal Reserve for a market correction? The planned benchmark rate of 2.1% by the end of this year may well prove to be too little, too late. To make matters worse, total assets held by the Federal Reserve still exceed $4.4 trillion dollars, changing very little since 2014—if the Fed was to expand this gigantic balance sheet further, a currency crisis will almost certainly ensue.