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Mid-cycle Recovery?

There are typically 4 phases to a business cycle in the U.S. and other western type economies – Early recovery, Mid-cycle, Late-cycle, and Recession/Contraction.

Is the economy headed toward the mid-cycle phase of its business cycle based on the vaccine rollouts, reopening timeline, economic numbers, stock market cycles, and current sector rotations?


Globally, China, which led the global economic recovery from the March 2020 pandemic low, shows signs of slowing. Additionally, fears are growing of a third wave due to the resurgence of Covid-19 cases from the more transmissible Delta variant.


Although the U.S. economic recovery and the stock market bull run can continue, investors need to pay attention to some of the leading indicators. Leading indicators include stocks, interest rates, cyclical versus defensive stocks performances, value versus growth stocks, and small-cap versus large-cap markets.

Early cycle recovery often entails a sharp recovery from a recession. Economic indicators (i.e., GDP, Industrial Production, etc.) go from negative to positive. Credit improves as Fed's easy monetary policies and the government's favorable fiscal spending policies lead to corporate business turnarounds. Business inventories are typically low, and sales growth rebounds sharply higher at this stage of the recovery.


Outperformance is visible within many of the economically sensitive sectors, including industrials and cyclical sectors. Other cyclical industries such as transportation and capital goods also improve in anticipation of a sustainable economic recovery. Select economically sensitive technology industries and materials stocks also show signs of recoveries as consumers and business spending return. Interest rate-sensitive sectors such as financials and real estate will also outperform during the early recovery phase as they benefit most from the low interest rates.


Mid-cycle recovery or the second phase of the economic cycle is historically the longest. Look for growth rates to begin to moderate here. Economic activities are still relatively strong, credit growth remains firm, and profitability is positive. However, monetary policies from the Fed will turn increasingly neutral as investors begin to anticipate a tapering.


As the economy transition from early recovery to mid-cycle recovery, growth rates begin to moderate across economically sensitive sectors. Interest rates will remain accommodating, and many cyclical sectors will continue to perform well. However, outperforming stocks that have moved beyond their peak growth periods will begin to witness peak demands and peak growth cycles. Although stock market performances can remain strong at this stage, it pares in comparison to the early cycle recovery phase.


Technology tends to perform the best, especially semiconductors and hardware names, which tend to show strong momentum, gaining confidence with new spending and hiring on the backdrop of a sustainable economic recovery. The communication services sector also performs well due to the strength of the media industry (i.e., a rebound in advertising spending).


As mentioned before, the mid-cycle phase is longer than any other stage of the economic cycle. It tends to be a volatile period as most of the market corrections often occur here. There are also frequent sector rotations and leadership sector changes. Since no sector consistently outperforms in the mid-cycle recovery phase, many investors look for sector rotations to maintain tactical outperformance.


During the late-cycle recovery, economic activity tends to peak. Growth can remain positive, but there will be visible signs of growth slowing. Inflation pressures begin to show up as a tight labor market leads to lower corporate profits and margins. The Fed also begins to send out messages to investors to expect tighter monetary policies.


The late-cycle tends to be like the early cycle recovery phase, at least based on time and duration, averaging approximately 1-year to 1.5 years. The energy sector tends to excel as inflationary pressures build and the economic expansion drives consumers and businesses to spend.


Defensive sectors such as consumer staples and utilities also perform well. But technology and consumer discretionary stocks will begin to underperform peers as inflationary pressures erode profit margins. Investors also tend to shift toward defensive areas in anticipation of a slowdown.


Technically speaking, we will be closely monitoring the following technical signs to confirm that the U.S. economy and business cycle is indeed entering its mid-cycle recovery:


Stocks are a leading indicator as this asset class discounts pivotal turns in business cycles. The enclosed chart shows the secular trends (8-20 years) of the U.S. stock market dating as far back as the 1920s. If the recent secular bull began in May 2013 via the technical breakout of the 2000-2013 secular bear/trading range trend, then this closely resembles either the 1949-1965 Nifty-Fifty structural bull rally (16 years) or the 1982-2000 tech/telecom structural bull (18-years). Since the current May 2013-present structural bull is only 8-years young, does this imply that there may be another 8-10 years left in this bull run?

Interest rates remain an important leading indicator of business cycles and economic conditions. The 10-year Treasury yields (TNX) will become increasingly volatile into the mid-cycle recovery as many investors will turn to interest rates for signs of inflationary pressures and recession signs. Key technical levels to monitor resistance is 1.70-1.765%, and above this to 1.90-1.95%. Support is 1.081-1.128%, and below this to 0.920-1.00%, and 0.85%.


S&P 500 Sector rotations can also offer clues to the transition from early recovery to mid-cycle recovery. The Relative Rotation Graph (RRG) currently shows three S&P sectors residing within the Leading Quadrant (i.e., technology (XLK), communication services (XLC), and real estate (XLRE)). Since only XLK and XLC are trending up this suggests money is rotating into the two technology-related sectors, offering signs that investors anticipate a mid-cycle recovery. Also, the only other S&P sector in a rising uptrend is the consumer discretionary sector (XLY), suggesting investors favoring the late-cycle economically sensitive consumer discretionary names (i.e., AMZN, NKE, TGT, CMG, SBUX, DPZ, etc.).


Performances between growth versus value and large-cap versus small-cap can offer insights into the specific stage of an economic cycle. Mid-cap, small-cap, and micro-cap tend to relatively outperform large-cap during the early parts of an economic recovery. Value versus growth is not as clear. However, there is a tendency for investors to favor stable, large-cap growth names as the economy nears a peak in its business cycle. The attached Relative Rotation Graph (RRG) study favor many large-caps and large-cap growth indexes, with four out of the six large-cap growth indexes trending higher and residing within the Improving and Leading Quadrants.


National Bureau of Economic Research (NBER), the arbiter of the beginning and end of U.S. business cycles, announced on 7/19/21 that the trough of the ensuing recession that began in Feb 2020 ended two months later in April 2020. NBER stated that the recession was very deep, but it was also the shortest on record at just two months. The committee also stated that this recession was different from prior recessions.

If the 2-month recession last year is different from the prior recessions, then will the subsequent recoveries also be different from previous recoveries. Will the early cycle recovery phase be longer or shorter than the prior recoveries? Will this then impact when the mid-cycle recovery begins and ends?


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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