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Morgan Stanley: The Expansion in Developed Markets Might Be Over

Brace yourself.

As traders are settling back into their routine after the slow summer months, things have started taking a turn for the worse in global markets.

Now one indicator is even pointing to the end of the expansion in developed markets. 

According to new research from Morgan Stanley, so many developed countries are showing enough signs of slowing, that its cycle indicators — which take macro, credit and corporate factors into account — are leading analysts led by Chief Cross-Asset Strategist Andrew Sheets to conclude that a downturn could be coming sooner than some may think. 

"The Morgan Stanley Cycle Indicators across the U.S., eurozone and Japan have stalled, highlighting the increasing risk that we have moved from 'expansion' to 'downturn' in [developed markets], even as our economics team flags upside risks to its macro outlook," the team said in a note published on Sundayy.

The team points out that if this is in fact the start of a cycle change, it would represent the shallowest recovery for the U.S. in more than 30 years.

Here's a look how these cycles have played out in the past, with recessions shaded. 

Screen Shot 2016-09-12 at 7.20.30 AM

There are a number of factors that are used in this model, and here are some of the main ones that are giving the team cause for concern.

Leading indicators are turning

According to the team, both the U.S. and Japan have seen leading indicators, or data points that typically turn before the broader economy, take a downward turn in recent months. 

It's tougher to get a loan

It has been tough to get a loan throughout the economic recovery, but many banks are reporting that standards are getting even tighter. While this doesn't always happen at the same time as a downturn, Sheets and his team still find the current levels troubling. "Of course, tighter lending standards have not always coincided with a turn in the cycle but the current elevated reading of the share of U.S. banks reporting tighter credit standards compared to those periods suggests that the shocks are not necessarily transitory," they write.

Corporate earnings still look bad

The term "earnings recession" has been mentioned a number of times in recent months, and there's little reason to expect that to change. Such an earnings recession has a strong relationship with economic downturns. "U.S. earnings per share [EPS] year-over-year growth is negative, having peaked in mid-2014," write Sheets & Co. "Since the 1990s, negative EPS growth has often, although certainly not always, coincided with downturns, although the pattern breaks down if we go further back in time."

In order to keep a close eye on the potential turn and gauge the likelihood of it actually happening, the team says there are a few indicators they will be keeping an even closer eye on.

  • Jobless claims, which they say typically trough within 28 months of the cycle peak in the U.S. 
  • The unemployment rate, since this also coincides with cycle peaks nearly 70 percent of the time. 
  • Consumer confidence, as this typically peaks along with the cycle and then sees major reversal during the downturn. 
  • Manufacturing, even though it's not one of the inputs into Morgan Stanley's indicator, is worth keeping a close eye on.
  • U.S. Treasuries, as the yield curve as measured by two- and 10-year notes is usually the flattest around cycle turns. 
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