Do conventional business cycle indicators give accurate signals in unconventional business cycles?
This question is gaining in relevance, because the US economy is by common consensus finally approaching what one might call full employment after years of running with significant spare capacity.
Macroeconomic risks tend to rise as economies move closer to full capacity, both because inflation risks rise, but also because recessions are never closer than when economies are running at full tilt.
The US business cycle is therefore slowly becoming a greater source of uncertainty and potentially risk not just to US investors, but also to investors elsewhere in the world economy, including emerging markets. This means that it is now very important that policy-makers and investors alike are measuring the business cycle in the right way.
As far as we can tell, very little attention has been paid to the question of how to measure the business cycle following the 2008/2009 crisis.
The overwhelming consensus among policy-makers and most market participants is that capacity utilisation is best gauged using traditional methods. That is by means of conventional business cycle indicators, such as unemployment, output gaps, labour participation rates, core PCE (personal consumption expenditure) inflation and inflation expectations.
These indicators, which have in common that they all seek to measure capacity in the domestic real economy, are currently signalling that the real economy may be moving closer to full capacity, but there are, as yet, no grounds for urgency when it comes to tightening policy.
The Fed itself reinforced this perception last week when the Federal Open Market Committee failed to raise its projections for future rate rises (the so-called dot plot).
Yet, this relaxed attitude about the state of the US business cycle may be misplaced, because there are good reasons to believe that conventional business cycle indicators are not picking up the warning signs.
Conventional business cycle indicators focus nearly exclusively on the real economy, including factor markets and growth-related variables, but the real economy is growing far slower than normal due to structural drags, so this may not be where the problem sits.
More importantly, overheating may be present in a completely different part of the economy, which is not usually considered in the context of the business cycle. If that is the case then the impression from conventional business cycle indicators that everything is fine is simply wrong and the business cycle could be further along the path towards overheating than most people believe.
Where are the risks of overheating emerging?
Two obvious areas are financial asset prices and the dollar. Both have experienced extremely rapid appreciation in the past 5-6 years from very low starting points. For example, in the immediate aftermath of 2008/2009 the dollar was trading at an eleven year low in real terms, while asset prices had dropped disastrously.
Understandably, the US government adopted policies that were intended to give a strong boost to asset prices and to shore up the dollar.
The US banking system was collapsing. Bringing capital into the financial system was essential in order to avoid depression, because the US financial system needs to roll debt equivalent to about 70 per cet of GDP every single year. Between them, quantitative easing (QE) and a strong dollar policy helped to create and attract capital from abroad and both the dollar and US asset prices began to rise spectacularly.
Unfortunately, the enthusiasm in policy cycles for inflating asset prices and maintaining a strong currency did not extend to structural reforms and deleveraging. This imbalance has over time created major distortions between valuations in financial and currency markets and the state of the underlying economy.
US stock prices today far exceed pre-crisis levels despite sharply lower trend growth rates, while US Treasury yields dropped below the rate of core CPI inflation along every segment of the yield curve as recently as July 2016, despite above target core CPI inflation.
In currency markets the dollar is now so strong that US companies are seriously struggling to compete against businesses in other countries.
Today, the structural problems remain unresolved, while asset prices are extremely elevated. The result is a freakish business cycle dynamic, where extreme misalignments of valuations are concentrated in currency and financial markets more so than in the real economy.
There may even be some destructive feedback loops at play, whereby the growing risk of macroeconomic dislocations due to the overvaluation of both financial asset prices and the dollar undermine the recovery in the real economy. There may also be a feedback loop, whereby loss of competitiveness due to the overvalued dollar is exploited by US politicians to justify trade protection, which clearly will ultimately come back to hurt the US economy.
REER – a measure of the feasible range for currencies within which economies tend to thrive, adjusted for domestic and foreign inflation
If conventional business cycle indicators have lost relevance in the current very unconventional business cycle then what is the best way to gauge macroeconomic risks?
We think the single best indicator in today’s conditions is the real effective exchange rate (REER).
As a stationary variable, the REER measures the feasible range for currencies within which economies tend to thrive, adjusted for domestic and foreign inflation.
The REER is therefore a business cycle indicator much like unemployment and output gaps with the important difference that REERs measure the state of the business cycle using prices and nominal exchange rates instead of quantities. This is far more appropriate and prudent in an environment where asset prices and currencies have become such important policy instruments and where governments abhor structural reforms.
Today, both the US REER and asset prices are sending clear messages: based on their valuations there is far less slack than what the conventional indicators suggest.
The US REER is currently at its most appreciated level since the height of the dotcom Boom, when markets wrongly priced a productivity miracle into the price of the dollar only to discover that the productivity miracle was in fact a bubble.
When the dotcom bubble burst the real dollar then fell for 11 years straight and only began its recovery in 2011. By now, however the real dollar is so expensive that the US economy only managed to eke out 1.6 per cent real GDP growth last year (of which more than half was due to population growth) despite negative real yields across the entire yield curve, massive funding from overseas, fiscal deficits and trillions in outstanding QE.
Real GDP growth is tracking an even slower rate of just 1.2 per cent quarter-on-quarter annualised so far this year, which means that 2017 may well be yet another year without the elusive ‘exit velocity’.
Where do emerging markets countries sit in REER terms? They are in exactly the opposite situation as that of the US. Emerging market REERs are at 13-year lows. Emerging market current account balances are continuing to improve sharply as a result.
Only last week, Poland, India, Indonesia, Singapore and Colombia all recorded large upside surprises on their current account and/or trade balances. It is important to understand, however, that the improvement in external balances in emerging markets goes far beyond just a few individual countries. Rather, it is a broad-based trend, which rooted in the massive shifts in exchange rates versus the dollar for nearly all emerging market countries in recent years.
The drop in emerging market nominal exchange rates of 40 per cent since 2010 and with inflation rates declining by one-fifth over the same period has depreciated emerging market real exchange rates by a massive 20 per cent, rendering them far more competitive than they were in 2010. No wonder the emerging market growth premium is picking up.
In conclusion, real exchange rates are today’s best cyclical indicators, because the real economy is sluggish and because overheating is showing up in asset prices and exchange rates. The former has been rendered sluggish by lack of structural reforms and deleveraging and the latter have been unnaturally inflated by policy-makers. REER misalignment is just as risky, if not more risky, than conventional overheating, because corrections are often accompanied by large cross-border movements of capital.
Given the overheating of US asset prices, the dollar investors would be wise to diversify their portfolios in other directions. Emerging markets offers an attractive destination for capital because they are on the other side of the US trade.
Emerging market real exchange rates are very competitive, so countries have room to grow, while asset prices are attractively priced after years of headwinds.
Jan Dehn is head of research at Ashmore. The views expressed above are his own and should not be taken as investment advice.