EPB Secular & Cyclical Economic FrameworkDec 29, 2021
The economy has long-term (secular) trends and shorter-term (cyclical) trends.
Secular trends are slow-moving and are impacted most closely by demographics and debt.
Cyclical trends are the 6-18 month fluctuations in growth that occur on top of the secular trends.
Asset prices respond very closely to the cyclical trends in economic growth.
- The EPB Secular & Cyclical Framework monitors both of these critical trends and details the probable path forward for asset prices.
EPB Secular & Cyclical Economic Framework
The two most critical variables in any economy are growth and inflation.
The level of growth or inflation is not as important as the direction because the economy and asset markets are relative, not static.
We are looking to forecast the expected future direction of these two variables, growth and inflation. Is the rate of economic growth going to rise or fall? Of the two factors, the direction of real economic growth is more important for asset price performance.
If economic growth DECLINES from 5% to 2%, that would be characterized as "slowing growth."
We cannot say that 2% growth is "good" or characterize the growth rate with subjective adjectives. We must define the landscape with objective descriptors like slowing, rising, falling, increasing, decreasing, accelerating, decelerating, etc.
If economic growth INCREASES from 0% to 2%, that would be characterized as "increasing growth."
In both examples, growth ended at 2%, but asset markets would respond to each situation radically differently. The path or the direction is where we focus, not the end level.
Now that we know the direction, not the level, is where we want to focus, over what time period should we measure these trends?
The EPB Macro Research framework considers two interconnected time periods and their impact on major asset classes: secular trends and cyclical trends.
Secular economic trends are longer-term, slow-moving trends in the economy that are most impacted by demographics and debt. Secular economic trends impact asset markets like interest rates over 3-5+ years.
Cyclical economic trends are the shorter-term fluctuations in growth or inflation that occur on top of the longer-term, slower-moving secular trend. Cyclical trends tend to change, on average, every 6-18 months.
Many investors and analysts only focus on the short-term and ignore the long-term, but this is a critical mistake.
Secular trends set the bias and constantly impact the cyclical trends.
If secular trends are persistently moving lower, pushing the long-term growth rate down, then the cyclical upturns in growth will be weaker and shorter-lasting on average. In contrast, the downturns in growth or inflation will last longer.
It is imperative to have a firm understanding of these secular and cyclical trends. Investors commonly mistake cyclical changes in the economy for structural or secular changes, which leads to poor asset allocation decisions.
You will always have the highest probability of success with an asset allocation decision when aligned with both the secular and cyclical economic trends.
In the sections below, we'll review the secular and cyclical trends in more detail.
After more context and information around each time frame, I will outline how the major asset classes respond to changes in the cyclical trends and conclude with some key takeaways about how this framework can help your investment process.
Secular Trends: 3-5+ Years
Secular economic trends are the slower moving, 3-5+ year trends in the direction of growth or inflation that are most impacted by demographics and debt.
Many investors ignore secular economic trends because they focus on asset price movements over the next several months, but this is a mistake as secular trends constantly influence short-term cyclical trends.
The chart below shows the long-term growth rate of nominal US GDP. Nominal GDP is a combination of both growth and inflation, and the chart clearly shows periods of sustained "increasing" growth and periods of continuously "declining" growth.
Importantly, the direction is more informative than the level.
Nominal long-term interest rates are highly correlated to the long-term direction of growth and inflation or nominal GDP growth.
The relationship between long-term Treasury rates and the secular trend in nominal GDP growth is an inseparable marriage that frustrates investors and analysts that are not keenly aware of these long-term trends.
Long-term interest rates cannot and will not rise on a sustained basis unless the secular (3-5+ year) trend in nominal GDP growth also rises.
Forecasting the secular trend in nominal GDP growth (growth and inflation) boils down to demographics and debt.
Overall, the trend in an economy is defined by how many people are working and the productivity rate of those workers.
Over time, nominal GDP growth is highly correlated to the growth rate of the labor force. The labor force is defined as people over 16 that are employed or actively seeking employment.
This relationship makes sense. If there are fewer people available to work, without a radical change in productivity, the overall growth rate in the economy will decline.
Nominal GDP is comprised of real growth and inflation. Demographics can explain a majority of the long-term trends in inflation.
The chart below shows the long-term growth rate in the labor force and the long-term CPI inflation rate.
The relationship between nominal growth and inflation is more clear, but even the long-term trend in real growth is impacted directionally by demographics.
The chart below shows the long-term growth rate in the labor force and the long-term growth rate in real GDP.
If we know that interest rates are closely tied to nominal GDP growth, and we also know that trends in the labor force highly impact nominal GDP growth, it makes a fair bit of sense that the growth rate in the labor force controls the long-term movements in interest rates.
The chart below shows the growth rate in the labor force and the Federal Funds rate.
The following chart shows the relationship between labor force growth and long-term Treasury rates.
The growth rate in the labor force is clearly a significant factor in determining the long-term trend of inflation, real growth, and thus nominal GDP growth. Forecasting the future growth rate of the labor force will therefore provide a very strong foundation for the ability of the economy to generate growth and also help guide the future path of interest rates, the most important variable in financial markets.
Over 80% of the labor force is comprised of workers aged 25-64. If we focus on that age cohort, we can see that the population growth rate is expected to continue trending lower through the end of 2030. As a result, the prime-age labor force growth will move lower, and overall labor force growth will move lower.
There is another reason to focus on this prime-age cohort. Most of the consumption power in the economy comes from the population ages 25-64.
As people reach their 30s, generally they are set in a career and start to think about household and family formation, which generates economic activity. Consumption remains strong until retirement years.
If we look at the relative share of the population aged 25-64, we can see that the US economy benefited from unbelievable demographics from the late 1960s through the early 2000s.
There was a rapid widening of the prime-age population, which was a major contributory factor as to why the inflation of the 1970s was sustained. Demographics were strong, and the younger working-aged population was better served to stomach continued price increases.
After 2009, the demographics trends shifted, and the prime-age population started to contract as a share of the total population. This is one reason why the last economic expansion came with some of the weakest growth we've seen in many decades. Consumers are aging and spending less.
Even more important than total consumption is the spending on high-powered cyclical items like housing and vehicles. Consumption of housing and cars requires more production, more labor and has more downstream effects like furnishing a home, increased fuel consumption, and more.
Consumption of housing and vehicles peaks in the 35-44 age cohort as compared to total consumption, which peaks in the 45-54 age cohort.
The 25-54-year-old population is a small subset but the most important for the engine of economic growth.
As a share of the total population, the 25-54 age cohort peaked in the late 1990s and has been declining ever since. Demographic forecasts suggest this trend will persist, just like the relative share of 25-64-year-olds.
From the late 1960s through the late 1990s, the US economy experienced the most significant benefit from demographics the country has ever seen and will likely see for many decades to come. This three-decade window of robust demographics is mainly responsible for the strong economic growth that occurred.
After the 1990s, and more intensely after the mid-2000s, demographics started to work against the US economy, bringing a natural drag to consumption, inflation, real growth, and nominal growth as referenced in the earlier charts.
To combat the natural drag that comes with worsening demographics, like most other advanced economies, the United States has decided to massively increase debt to offset this natural drag rather than accept the destiny of demographics.
Unfortunately, this path of increased debt only works to create short-term spurts in growth rather than lasting gains, and after the debt wears off, the demographics have only deteriorated even further.
Once demographics turned negative, the US tried to generate a housing boom using private sector credit. More recently, corporate debt and government debt have radically increased, all with the same intent of offsetting what is an unstoppable path of declining demographics.
This leads to the second major secular factor that impacts real growth and inflation, or nominal GDP growth: debt.
Higher debt levels drain an economy of productivity if the debt is not being used to generate a future income stream to repay both the principal and the interest.
If the debt does not generate a lasting income stream (unproductive debt), then future income must be diverted from a productive use to repay the principal and the interest.
The best way to measure whether the economy uses debt productively or unproductively is the debt to GDP ratio.
GDP is closely associated with national income. If the debt is used productively and increases overall national income, the debt to GDP ratio will decline. Suppose the debt is being used unproductively and not furthering the income-producing capacity of the nation. In that case, the debt to GDP ratio will rise, and future productivity growth will fall.
In the United States, total debt from all sources (public and private) is well over 350% of GDP.
If we flip this ratio around and look at the GDP to debt ratio rather than the debt to GDP ratio, we can see how much GDP or national income the economy generates per dollar of debt capital used.
In the 1970s, the US economy generated almost 70 cents of GDP per dollar of debt capital. As of 2020, the US economy generated roughly 25 cents of GDP per dollar of debt capital, highlighting the reduced productivity growth in the economy.
Real GDP measures growth after inflation. Real GDP per capita measures growth after inflation per person in the economy and is closely associated with productivity or the standard of living.
You can think of real GDP per capita growth as productivity growth or the growth rate in the standard of living.
The long-term real GDP per capita rate has declined sharply over the last 50 years, down to less than 1.25%.
The decline in the rate of real GDP per capita is associated with reductions in the efficiency of using debt capital (higher debt to GDP ratio).
The concept of diminishing marginal returns is fundamental in economics.
Any factor of production (land, labor, and capital) can be overused.
When a factor of production is used modestly, output or real GDP per capita growth increases. Eventually, the gains from continuously using that factor of production flatten out and then turns lower upon even greater overuse.
We can think about this concept using labor. How many people does it take to wash a car?
Two people can likely wash cars faster than one person. Four people might produce better results compared to two people. At some point, however, adding more labor will yield worse results. Would 40 people washing the same car be more or less productive than four people? This is diminishing returns at work.
When considering how debt impacts an economy, it is critical to consider diminishing returns rather than assuming that more capital or money will always yield better results.
Various academic studies provide guidelines regarding the level of debt to GDP that hurts economic growth, including:
- BIS paper "The Real Effects of Debt"
- IMF paper "Too Much Finance"
- IMF paper "Public Debt and Growth"
- Journal of Economic Perspectives paper "Public Debt Overhangs"
- American Economic Review paper "Growth in a Time of Debt"
From 1929 through 1999, real GDP per capita increased at a sustained long-term rate of 2.3%.
Based on most academic research, in the United States, we crossed into dangerous debt levels around the year 2000. In this context, "dangerous" does not imply a pending economic crash but rather that increasing debt will continuously yield worse results (diminishing returns).
From 1999 through 2019, before the COVID pandemic, the real GDP per capita rate increased by just 1.2%, a material reduction in productivity that supports the findings of the five critical academic studies listed above.
A continued build-up of unproductive debt, defined by an increasing debt to GDP ratio, will result in a further decline in the long-term rate of real GDP per capita.
The decline will intensify as debt levels rise.
Key Points From Secular Trends: Secular trends are the slower-moving forces that impact economic growth on a 3-5+ year basis. Demographics and debt most influence secular trends. Slower population growth is a negative force for growth, and older demographics reduce economic growth. Higher levels of debt to GDP reduce productivity and result in slower rates of real GDP. The combination of slower population growth, older demographics, and higher debt levels is a strong cocktail for a continued decline in economic growth and inflation over the 3-5+ year window.
Cyclical Trends: 6-18 Months
Cyclical trends are the 6-18 month fluctuations in the direction of economic growth. It is extremely rare for a growth rate cycle to last shorter than six months, but since standard business cycle and growth cycle dating methodologies contain some element of judgment, sharp and severe declines such as the COVID recession are classified as separate cycles despite lasting just a couple of months.
We can define the cyclical trends in the economy using highly reliable data points from what I call the "four corners" of the economy. Every economy has income, consumption, production, and employment.
These four variables work together in a cyclical fashion.
More income leads to more consumption which requires increased production and more employment. This cycle can also work in reverse.
The National Bureau of Economic Research outlines rough criteria for dating business cycles. Some element of judgment and subjectivity is allowed in the dating process.
Because a recession must influence the economy broadly and not be confined to one sector, the committee emphasizes economy-wide measures of economic activity. The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.
At EPB Macro Research, we take four measures (one from each corner), outlined by the NBER to be important in the business cycle dating process, and track the changes in growth.
The chart below shows the growth rate of industrial production, nonfarm payrolls, real personal consumption, and real personal income excluding government transfer payments.
Since these data points broadly define the business cycle, they are called "coincident indicators." These indicators do not lead or lag the business cycle; they coincide with the peaks and troughs.
Given the subjectivity allowed in the dating process, these four data points are not the only coincident indicators we use to monitor the economy. Other important data points include real retail sales, real aggregate income, and manufacturing shipments, for example.
The main point is that we want to track the trending direction in growth from all major sectors of the economy, broadly defined as production, employment, income, and consumption.
The four measures in the chart above are a reliable basket, all included in the NBER business cycle dating process.
At EPB Macro Research, we also combine these four data points into one composite index called the "EPB 4-Factor Coincident Index" for a real-time measure of the trends in real economic growth.
I create multiple coincident indicator baskets using various combinations of data from each of the four corners, all with results that are broadly consistent with the chart above. The main index I use is charted above with the four data points directly listed by the NBER.
The trending 6-18 month direction in real economic growth defined by the coincident indicators above determines the growth rate cycle or the cyclical trends in the economy.
Before the COVID pandemic, the US economy had several distinct growth rate cycles.
Every growth rate cycle carries increased recession risk, and all recessions begin during growth rate cycle downturns.
However, not every cyclical downturn in growth concludes in a recession. Sometimes, as graphed above, the growth rate bottoms before reaching negative territory and starts to re-accelerate. This is called a "soft-landing."
A complete business cycle recession generally requires a sustained negative growth rate that is visible across multiple sectors of the economy (income, production, employment, consumption.)
Due to the secular economic trends pushing the overall growth rate in the economy lower, cyclical downturns have lasted longer, on average, than cyclical upturns over the past 25 years.
Cyclical upturns have lasted 13 months on average, while cyclical downturns have lasted 18 months on average.
Asset prices respond very strongly to the changes in the cyclical direction of coincident growth.
The trending direction of coincident growth is critical. However, these indicators do not tell us where the growth rate is heading, only the current trend. To understand where growth is headed, we need to deeply study and track leading economic indicators.
Key Points From Cyclical Trends: Cyclical trends are the 6-18 month fluctuations in growth that occur on top of the secular trends. Cyclical trends in growth are defined by the combination of growth from all four corners of the economy, including income, consumption, production, and employment. Not all cyclical downturns in growth end in a full business cycle recession. When economic growth declines but re-accelerates before reaching negative growth, this is called a "soft landing." Leading indicators provide clues about the future direction of coincident economic growth, and thus, asset price performance.
How Assets Respond To Changes In Cyclical Trends
The cyclical or 6-18 month trend in the direction of growth is the most important fundamental factor impacting asset price performance.
The secular economic trends cannot be overlooked. A firm understanding of the secular economic trends helps set the bias for the cyclical trends and improve the ability to forecast turning points through the secular bias.
Retroactively, we can define growth rate cycle upturns and growth rate cycle downturns using the peaks and troughs in coincident growth. We can also use a third party to date the growth rate cycles for consistency and verification. The Economic Cycle Research Institute publishes growth rate cycle and business cycle dates utilizing a methodology similar to the NBER business cycle dating process.
The chart below shows the growth rate cycle upturns and growth rate cycle downturns, defined by ECRI.
Armed with these cycle dates, we can study the performance of asset prices during the cyclical upturns in growth and the cyclical downturns in growth.
There are several key takeaways to learn from studying the performance of assets during growth rate cycle upturns and downturns.
Major stock indexes like the S&P 500 have significantly higher average returns during cyclical upturns in coincident growth compared to cyclical downturns in coincident growth.
The chart below shows that since 1996, the average annualized return for the S&P 500 during a cyclical upturn was almost 20%. The average annualized return for the S&P 500 was just 5.3% during cyclical downturns in coincident growth.
The S&P 500 is generally a defensive stock index due to the high concentration of mega-cap technology stocks. The performance disparity during cyclical upturns and cyclical downturns in coincident growth is even more significant with a more cyclical or more risky stock index such as the Russell 2000.
Conversely, safe assets like long-duration Treasury bonds enjoy stronger performance during cyclical downturns in coincident growth compared to upturns in coincident growth.
This analysis can get more granular, comparing different size factors, style factors, sectors, and more assets.
When incorporating economic cycles into your investment process, here are eleven comparisons to think about:
During a Growth Rate Cycle Upturn:
- Stocks over Treasury bonds
- Small-cap stocks over large-cap stocks
- Value stocks over growth stocks
- Cyclical stocks over defensive stocks
- International stocks over domestic stocks
- High beta assets over low beta assets
- Leveraged balance sheets over quality balance sheets
- Industrial commodities over gold
- Low duration over long duration
- Investment grade and high yield credit over risk-free Treasury bonds
- Foreign currencies over US Dollars
During a Growth Rate Cycle Downturn:
- Treasury bonds over stocks
- Large-cap stocks over small-cap stocks
- Growth stocks over value stocks
- Defensive stocks over cyclical stocks
- Domestic stocks over international stocks
- Low beta assets over high beta assets
- Quality balance sheets over leveraged balance sheets
- Gold over industrial commodities
- Long duration over low duration
- Treasury bonds over investment grade or high yield credit
- US Dollars over foreign currencies
Ideally, when making an asset allocation decision in line with the growth cycle, you want to be aligned with as many comparisons as possible.
For example, if the economy is in a downturn, allocating to growth stocks might be okay, but even better would be large-cap, domestic, quality balance sheet, low beta growth stocks.
Summary & Key Takeaways
The economy has secular and cyclical trends in the rate of growth and inflation.
For the purposes of asset class rotation, the trends in real growth are by far more critical than inflation unless long-term inflation expectations become unanchored.
Even throughout the COVID inflation period, long-term inflation expectations have remained mostly stable, and asset prices have still responded very directly to the changing direction of cyclical coincident growth.
Secular trends influence economic growth and asset prices over 3-5+ years and are most influenced by demographics and debt.
Slower population growth, older demographics, and higher levels of debt to GDP ensure that there will be a constant drag on the rate of real economic growth.
Cyclical trends are the 6-18 month fluctuation in growth determined by income, production, consumption, and employment.
Secular trends impact cyclical trends because if the gravitational force in the economy is pulling the growth rate lower, then cyclical upturns will be more fleeting, and cyclical downturns will be longer-lasting.
When the 6-18 month trend in growth is rising (cyclical upturn), risky assets generally outperform defensive assets.
When the 6-18 month trend in growth is falling (cyclical downturn), risky assets have a higher probability of declining, and it is more prudent to overweight defensive assets.
Leading Indicators & Future Updates
For regular updates on these critical secular and cyclical trends, as well as in-depth coverage of leading economic indicators, I provide two reports.
The EPB Monthly Coincident & Leading Indicators Update is a once per month report covering cyclical (6-18 month) trends in growth/inflation and the expected impact on asset prices.
The EPB Quarterly Secular Trends Update is a once-per-quarter video presentation updating this entire framework with a focus on long-term (3-5+ year) trends in growth/inflation and the impact on asset prices.
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