Markets & Economy
As much of the global economy climbs out of the pandemic-induced downturn, investors are scrutinizing every new economic data point for clues to the outlook for growth and inflation. I think they should also take the 30,000-foot view afforded by financial cycles, which can offer a long-term perspective on the trajectory of an economy. My latest reading of global financial cycles shows very positive signals for the U.S. economy and dollar over the next few years, alongside more cautious signals for Europe and China.
Financial cycles track house prices and the amount of private sector debt in an economy. The concept, developed by the Bank for International Settlements (BIS), rests on the observation that trends in these factors develop slowly and tend to influence each other. This reflects the critical role of credit in financing home purchases and construction. Financial cycles often last much longer than the business cycle, which is a far more mainstream indicator that focuses on fluctuations in economic output. In my view, financial cycles provide a powerful tool that investors can use to assess the outlook for economies and asset class returns.
There are four distinct phases of the financial cycle, corresponding to the trend of leverage in an economy. Peaks in the financial cycle can provide an early warning of financial crises. In fact, the last peak in the U.S. financial cycle in 2006 preceded the global financial crisis. Additionally, turning points in financial cycles often coincide with changing fortunes for equity and bond markets. My analysis of more than 40 years of asset class returns shows that bonds tend to fare better than equities around financial cycle peaks, while equity returns have typically been stronger around financial cycle troughs.
Four phases of the financial cycle: How equities and bonds have typically fared
I’ve been tracking the financial cycles of nearly 40 countries around the world for the past seven years. Here are four key trends that I’m seeing:
1. The U.S. financial cycle is very strong
The U.S. stands out as one of the few countries experiencing an acceleration in both the housing and credit components of the financial cycle, which bodes well for U.S. economic growth over the next few years. In particular, the surge of U.S. house prices has given the financial cycle a new boost. U.S. house prices rose almost 10% year over year in the fourth quarter of 2020, exceeding the growth rate during the run-up to the global financial crisis. Private credit also expanded as the Federal Reserve cut interest rates to near zero and pumped liquidity into the financial system in response to the economic effects of the COVID-19 pandemic. U.S. private debt reached 160% of gross domestic product in the fourth quarter of 2020, up from 148% a year earlier, according to the Fed and the Bureau of Economic Analysis.
U.S. financial cycle could have another leg up
Despite the most recent acceleration in U.S. house prices and credit growth, the U.S. financial cycle remains “late cycle.” My baseline forecast is that the cycle will peak and begin to transition into phase 1 in late 2023 or early 2024. However, this is beyond the 2022 peak that I expected prior to the COVID-19 outbreak. My current forecast could even prove too bearish considering the potential for more fiscal stimulus, the successful rollout of COVID-19 vaccines and the Fed’s stated intention to maintain accommodative monetary policy in the face of nascent inflation. On the other hand, if the Fed were to tighten monetary policy sooner than expected, higher interest rates would most likely have a dampening effect on U.S. house prices and the growth of private credit in the economy, leading to a weaker financial cycle.
A strong correlation between U.S. house prices and private credit
2. A stronger U.S. dollar and weaker euro may be ahead
Foreign exchange movements reflect the relative strength of currencies, so I focus on the relative strength of different countries’ financial cycles when considering where currencies may be heading. The relative strength of the U.S. financial cycle suggests that its economy is diverging significantly from the rest of the world. The sharp rise in U.S. house prices underscores the point, with growth in the fourth quarter of 2020 more than double the median of a basket of 16 developed economies. While my baseline forecast calls for the U.S. financial cycle to slow in the next few years, right now it has more momentum than cycles elsewhere, particularly in Europe. This matters for the trajectory of the U.S. dollar.
U.S. housing boom outpacing other developed markets
Now let’s consider the euro area financial cycle. A side-by-side comparison of the U.S. and euro area cycles shows that both have strong momentum. However, I am forecasting a higher and later U.S. cycle peak considering the strength of the U.S. housing boom. Europe is seeing a slower recovery from the economic downturn, due in part to a less-aggressive euro area fiscal and monetary policy response to the pandemic. I expect the euro area cycle to approach its peak in early 2022, about two years before the U.S. cycle.
U.S. vs. euro area financial cycles
All of this should be bullish for the U.S. dollar and bearish for the euro. Expectations for comparatively stronger U.S. growth should push U.S. real interest rates higher, which would support dollar strength. Ultimately, this could extend the decade-long bullish dollar cycle and put on hold a shift to a bearish dollar cycle.
To hold a long-term bullish view on the euro through the financial cycle lens, we would need to see a lot more housing and credit growth across the euro area. Given that Germany is the largest economy in the euro area, this may ultimately depend on the willingness of German households and firms to take on more debt.
3. Divergence within the EU could pose a dilemma for the European Central Bank
I am skeptical that we will see a strong acceleration in Germany’s financial cycle. Right now, Germany’s cycle is strong, driven by a booming housing market. But my forecast is for the cycle to peak and transition into phase 1 in 2022, mainly because forecasts of German nominal income growth are not strong enough to sustain the house price increases. While the European Central Bank’s (ECB’s) monetary policy is very loose and fiscal policy is stimulative, these policy tailwinds are not strong enough to generate sustained reflation in Germany. Consequently, the country’s private sector credit growth remains muted.
In Italy, the financial cycle is moving higher, but its momentum is unlikely to be strong enough to offset a rollover of the German cycle. Typically, the two countries’ financial cycles diverge, and it looks like this may be happening again. If this divergence continues, it will create a headache for policymakers at the ECB. They will once again face the policy dilemma of whether to set interest rates to suit macroeconomic conditions in the core euro area — or on the periphery.
Financial cycles for Germany and Italy may be diverging
4. China’s financial cycle is reaching a peak
After surging since the depths of the global financial crisis, China’s financial cycle seems to be peaking. The long surge reflected massive leveraging by Chinese households and companies, and it got a further boost from government stimulus in 2020 in response to the pandemic.
Now, authorities in China are trying to manage house price and credit growth to ensure that the economy gradually slows without triggering a disorderly deleveraging scenario. I expect this to hit the economy with a lag of about 12 months. If it does, it will be a headwind for global growth and commodity prices, with a potential negative effect on emerging markets currencies. Most of the 16 emerging markets that I follow are in the early stages of their financial cycles (phase 1 or 2); a stumble by China could hold them back from the later stages of the cycle that signal stronger economic growth.
China’s financial cycle likely to have ramifications for emerging markets
Investors have many ways to assess the economic outlook, and I believe that studying financial cycles can be a useful part of that toolkit. By focusing on the direction of the housing and credit cycles, they offer a longer-term perspective than business cycles. A useful analogy is to think of financial cycles as seasons and business cycles as changing weather patterns. When a country is late in its financial cycle, a recession may not be imminent, but the best of times may be behind it. Comparing the financial cycles of different countries can help investors identify where large GDP growth headwinds or tailwinds may be developing.
Currently, financial cycles suggest that the U.S. economy will outperform the rest of the world over the next couple of years. However, with many advanced economies — including the U.S. — being late in their financial cycles, they may be approaching a period of deleveraging and economic contraction. At the same time, emerging markets are generally in the earlier phases of their financial cycles, suggesting that they may see a period of relative strength as the advanced economies pass their cyclical peaks. Until then, the potential for a stronger U.S. dollar and a slowing China could mean a bumpy road for many developing countries.
Emerging markets tend to be early in the financial cycle
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