Welcome to the Benjamin Button economy

September 26, 2024
Originally written by Jared Franz for Capital Group

In the 2008 movie, The Curious Case of Benjamin Button, the title character played by
Brad Pitt ages in reverse, transitioning over time from an old man to a young child.
Oddly enough, I think the U.S. economy is doing something similar.
Instead of the typical four-stage business cycle — early, mid, late and recession — we
have witnessed since the end of World War II, the economy appears to be transitioning
from late-cycle characteristics of tight monetary policy and rising cost pressures back to
mid-cycle, where corporate profits tend to peak, credit demand picks up and monetary
policy is generally neutral.
The next step should have been recession but, in my view, we have clearly avoided that
painful part of the business cycle and essentially moved backward in economic time to a
healthier condition.

U.S. economy goes back to the future

How did this happen? Much like the movie, it’s a bit of a mystery, but I think the
Benjamin Button economy has resulted largely from post-pandemic distortions in the
U.S. labor market that were signaling late-cycle conditions. However, other broader
economic indicators that I think may be more reliable today are flashing mid-cycle.
If the U.S. economy is mid-cycle, as I believe, then we could be on the way to a multi-
year expansion period that may not produce a recession until 2028. In the past, this
type of economic environment has produced stock market returns in the range of 14% a
year and provided generally favorable conditions for bonds.

The unemployment rate gap

Stay with me for a moment while I explain my methodology. Instead of using standard
unemployment figures to determine business cycle stages, I prefer to look at the
unemployment rate gap. That’s the gap between the actual unemployment rate
(currently 4.2%) and the natural rate of unemployment, often referred to as the non-
accelerating inflation rate of unemployment, or NAIRU. That number typically falls in a
range from 5.0% to 6.0%. Simply put, it’s the level of unemployment below which
inflation would be expected to rise.
While this is a summary measure of dating the business cycle, it is based on a more
comprehensive approach that looks at monetary policy, cost pressures, corporate profit
margins, capital expenditures and overall economic output.
The unemployment gap is a measure that can be tracked each month with the release
of the U.S. employment report. The reason it has worked so well is because the various
gap stages tend to correlate with the underlying factors of each business cycle. For
example, when labor markets are tight, cost pressures tend to be high, corporate profits
fall and the economy tends to be late cycle.

Unemployment data signals rise of a mid-cycle economy

This approach also worked nicely in pre-pandemic times, providing an early warning
signal of late-cycle economic vulnerability in 2019. That was followed by the brief
COVID recession from February 2020 to April 2020.
It’s likely that the pandemic has distorted the U.S. labor market, structurally and
cyclically. For example, the labor force participation rate experienced an unprecedented
decline as global economic activity came to a virtual standstill. That was followed by a
remarkable rebound in the participation rate above pre-pandemic levels for prime-age
(25- to 54-year-old) workers.
In other words, traditional ways of looking at the unemployment picture are now less
useful tools for calibrating broader economic conditions. They've become less
correlated with classic business cycle dynamics. Not recognizing these changes can
lead to overly optimistic or overly pessimistic assessments of the cycle.

Market implications: Stocks and bonds could do well

My macroeconomic view drives my equity market view. As I said, an economy that is
mid-cycle has tended to produce equity returns of approximately 14% on an annualized
basis. Small-cap stocks have generally outpaced large caps, value has outpaced
growth, and the materials and real estate sectors have generated the best returns.
These figures are based on a Capital Group assessment of market returns from
December 1973 to August 2024.

As always, it’s important to acknowledge that past results are not reflective of results in
future periods. But if the U.S. economy continues to grow at a healthy rate — 2.5% to
3.0% in my estimation — that should provide a nice tailwind for equity prices. Over long
periods of time, when the U.S. economy grows above its potential 2.0% growth rate,
that type of environment has generally supported better-than-average stock market
returns.

A mid-cycle economy has provided favorable market returns

Mid-cycle economies have also generally produced a favorable backdrop for fixed
income markets. During the same period referenced above, long-term U.S. government
bonds returned 4.7% on an annualized basis, while long-term corporate bonds returned
5.0%.
If the Fed continues to cut interest rates, I believe that could provide an even more
favorable environment for bonds over the next few years. Given my positive economic
outlook, I don’t think the Fed will reduce rates as much as the market expects. Inflation
hasn’t been defeated quite yet. It’s still slightly above the Fed’s 2% target, so following

last week’s 50 basis point cut, I think central bank officials will be cautious about future
rate cut actions.

Election uncertainty? Not really

With U.S. elections about a month away, you may be wondering if my outlook for the
economy and markets will change depending on the outcome. The answer is no. Over
the years, I’ve learned to be election agnostic. Promises made on the campaign trail
often look nothing like the policies enacted after Election Day and, therefore, I generally
avoid taking political considerations into account.
As an economist, I believe political gridlock is not all bad, and it has tended to be the
norm in recent decades. I think we are likely to see a split government again in 2025,
with neither party gaining full control of the White House, the Senate and the House of
Representatives. That should narrow the potential for wild policy swings and put the
focus back on the fundamentals: the economy, the consumer and corporate earnings.

Original article:

https://www.capitalgroup.com/advisor/insights/articles/welcome-benjamin-button-economy.html