The US economy tends to move in a pattern, with alternating periods of ups and downs. But, if you're just tracking the data, it can be surprisingly tricky to figure out where it is in the flow. That’s why Morgan Stanley developed a business cycle model that strips away the conflicting signals to get a better read on where the economy sits. And for the past year, it’s been perched squarely on “downturn”.
Morgan Stanley’s model tracks a lot more than just hard economic data like jobs and manufacturing production. It factors in soft data like consumer confidence, market data like the yield curve, credit data like loans, and even corporate aggression data like mergers and acquisitions (M&A) and bond issuance.
It analyzes all that data, paying attention to how the different economic indicators are changing over time, not just whether they’re high or low. And by combining the data, it tracks how many different indicators are moving in the same direction, and for how long.
See, for the cycle to be at a turning point, more than 60% of the model’s indicators have to be getting stronger or weaker for three months in a row, compared to their levels six months prior. This creates a small lag in its signaling, but it ensures that the cycle indicator doesn’t jump around constantly between phases and improves its reliability.
This method has a lot of advantages: it’s both theoretically sound and empirically proven, it’s rule-based (meaning it’s less subject to biases), it’s comprehensive, and it summarizes the economy into one easy-to-understand gauge. That makes it a great tool for keeping an eye on the big picture and separating the signal from the noise.
The model’s been parked in “downturn” since the end of January 2023, following its shift from “expansion”. And though there was recently a slightly positive uptick, the data hasn’t improved quite enough to move the needle back to expansion. During the downturn phase, economic figures can still appear solid but then either degrade or plateau. That’s why, for the model to shift back to expansion, it needs to clock a consistent, broad-based improvement. Remember, that threshold is high – over 60% of the components must show strength compared to their status six months prior, and that trend must hold for three consecutive months.
That’s a tall order right now: the US job market is showing early signs of fatigue, consumer confidence is in a rut, the yield curve is still inverted, personal income has been trending downward, manufacturing activity has been sluggish, and the mergers and acquisitions market has been quiet. The model has tallied it all together to reach its dreary conclusion: downturn.
It doesn’t mean a recession is imminent or that stocks will crash. But a downturn signal has historically meant a worse backdrop for stocks, and a better environment for bonds.
Morgan Stanley calculated what it deems to be a “cycle-optimized portfolio” –i.e. the best investment mix for different phases –and suggested a reduced exposure to US stocks and riskier bonds, and a higher allocation to cash, high-quality bonds, and international stocks in the downturn phase.
With the cycle indicator pointing to downturn for the past year, it probably seems counterintuitive that stock prices have surged. But those gains are mostly because investors have been betting on a robust economic rebound, which would likely shift the indicator back to expansion – a move that’s not at all unprecedented. Similar flips happened in the 1980s, 1990s, and early 2000s.
In fact, the economic backdrop now looks eerily similar to that of the mid-1990s. Back then, after a series of rate hikes in 1994, the Federal Reserve opted for a pause, followed by minor rate cuts that helped propel the economy and stock market to new heights. If investors are right, then the cycle might soon switch to expansion again and we might see another leg up in growth and stock prices.
But other scenarios are possible too. One is that economic growth weakens further and the model shifts straight to “repair” – a phase that would likely see stocks drop as investors reassess their optimistic outlook. Another is that the model shifts temporarily to expansion, before falling back to downturn and repair, as it did in the late 1990s. (It didn’t end well for stocks back then.)
So this is where we are now: economic growth is weaker than the data suggests, and investors are betting big on a move back to expansion. If they’re right, stocks may continue to perform well. But if they aren’t, we might see a big shift in market leadership, with bonds outperforming stocks.
So if you trust the model’s signal, it might be prudent to play it safe both across asset classes – keeping your allocation to stocks reasonable, and owning some bonds – and within asset classes – rotating your US stocks into international ones, and your riskier, high-yield corporate bonds into more defensive, investment-grade ones.
