Chapter 17

The Economic Cycle

Round it goes, where it stops nobody knows

‘An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.’

Laurence J. Peter

We are going to have a crash course in economics before turning our attention to Tactical Asset Allocation (TAA). In this chapter we will look at the basics of economics since economic conditions are the backdrop for the performance of asset classes.

The economic cycle

TAA aims to identify the current and next stages of the economic cycle to position the portfolio accordingly. The economic cycle (business cycle) is the economy’s natural fluctuation between growth and contraction of output, jobs, income and spending.

Trend rate of economic growth is average sustainable growth rate over a long time period. It is determined by growth in productive capacity, consistent with low inflation. Actual, short-term growth is quite volatile, drifting away above and below trend growth rate.

This volatility around trend growth is the economic cycle, going through four main stages:

1. Expansion.
2. Slowdown.
3. Recession.
4. Recovery.

Expansion or boom (growth) is when national output is rising faster than trend growth rate. Its origins are a virtuous circle amongst the consumer, corporations and the government.

Demand for goods and services companies sell begins with the consumer. Consumption is supported by personal wealth effect, fuelled by rising real income, falling unemployment and appreciating house prices.¹ People feel confident and wealthier so they spend money and save less.

Due to rising demand, firms are more profitable. Businesses invest in capital goods (capital expenditure – CAPEX) and hire employees to expand capacity to meet increasing demand. The government collects more taxes, as unemployment falls and corporate earnings rise. The public sector expands, creating more jobs.

As interest rates are low, asset bubbles might inflate in property, stock and bond markets. Individuals and corporations may over-leverage themselves due to positive sentiment, low borrowing costs and complacency. Leverage further inflates asset prices. Valuations become stretched. Imbalances and excesses are created.

Eventually, the economy overheats, running a positive output gap (actual output exceeds potential output), leading to inflationary pressures due to demand surpassing supply.

The slowdown (optimism) stage is when growth decelerates, but GDP is still rising (the level of GDP growth is still positive, but momentum is declining). That is, the second derivative of growth rate (the pace of growth rate) is decreasing. If the economy slows without falling into a recession, it is called soft-landing; otherwise it is hard-landing.

A number of factors can cause a slowdown. Inflation that was rising during late expansion stage erodes real income so consumption retreats. Central banks may increase interest rates to tame inflation, causing bursting of asset bubbles and the wealth effect to fade. As rates rise, the currency tends to appreciate, hurting the competitiveness and profitability of exporters, as their produce is more expensive. Now, with rising borrowing costs, leverage starts to bite. Excesses that were built during the expansion cause problems.

People may maintain optimism, hoping the economic expansion will continue. However, with the economy showing signs of weakness, elevated asset prices, rising borrowing costs and inflation, confidence is fragile. The economy can tip over; it is losing steam.

The recession (despair) stage is when GDP is contracting. Technically defined, a recession is a fall in real GDP for two consecutive quarters. Often, some systemic shock, such as a large debt default, leads to a recession.

Negative growth leads to increasing unemployment, as corporations face over­capacity and scale down. Real income decreases and with it consumption, corporate profitability, government’s tax revenues and spending (austerity). Fiscal deficit rises and the currency depreciates.²

A negative wealth effect caused by a dropping stock market, housing market and income leads to gloom and tumbling confidence. Inflation falls because of weak demand for goods and services. Central banks ease monetary policy. Individuals and corporations de-leverage, repairing their balance sheets. Corporations cut costs and become more efficient, leaner and meaner.

A more severe recession is a depression: a prolonged and deep recession, leading to a significant fall in GDP and average standard of living. In a depression, real GDP can fall by more than 10%. In the 1930s, the Great Depression hit the USA and the rest of the world.

The recovery (hope) stage is when GDP growth rate turns positive from the trough it reached during the recession. Eventually, after the recession has run its course, the economy starts to recover, running a negative output gap (actual output lags potential output). Things start looking normal again.

Mending confidence of individuals and businesses is critical for a turnaround. Confidence leads to increasing consumption, rising corporate profits, hiring, growing government tax collections, public expenditure and investments.

Inefficiencies and leverage of the expansion stage have been addressed. Individuals, corporations and the economy are efficient and de-leveraged. Weak currency helps exporters. Excesses are eliminated and the economy is set for repair, when conditions stabilise.

Often, central banks and governments deliberately attempt to stimulate demand to kick-start a recovery. Central banks use monetary tools, such as cutting interest rates, now that inflation has eased, and quantitative easing (QE) when conventional monetary policy is insufficient.

Governments use fiscal policy to influence the economy. Fiscal policy is a government’s actions of adjusting revenues (mainly taxes), borrowing and expenditures. In a slowing economy, the government can cut taxes and increase spending to reflate it. National infrastructure projects, for example, can create employment and demand for raw materials. When the economy accelerates and overheats, the government can raise taxes and cut spending to slow it down.

After recovery, the economy normally heads back to expansion. However, it can fall back into a recession, called a double-dip recession.

The four economic stages can be described using a four-by-four matrix of GDP growth relative to trend and inflation. In expansion, GDP and inflation are both rising. In slowdown, GDP is slowing, whilst inflation is rising. In recession, both GDP and inflation are falling. In recovery, inflation is falling, whilst GDP is rising.

Other atypical economic stages include deflation and stagflation. Deflation means negative inflation. The concern is that consumers postpone spending because prices are expected to fall in the future. A deflationary spiral hit Japan in the 1990s – dubbed ‘the lost decade’.

Stagflation means negative growth with high inflation. This is a tricky situation as it is difficult to stimulate the economy. Central banks cannot cut rates as inflation is high.

Goldilocks is when growth is not too hot to generate inflationary pressures and not too cold to enter a recession. This is a perfect regime for most asset classes, across both equities and bonds.

The role of central banks has increasingly taken centre stage since the 2008 crisis. Central banks’ primary role is setting monetary policy to control money supply to smooth the economic cycle and inflation. They do so by setting short-term interest rates and cash amounts that banks need to keep as reserves.

When inflation is high, central banks can increase borrowing costs, making money more expensive, dampening demand and reducing inflation. Recently, central banks, such as the Bank of England (BOE), the Federal Reserve (Fed), the European Central Bank (ECB) and Bank of Japan (BoJ), have started focusing more on reflating economies, using unconventional monetary policies (QE and forward guidance).³

QE means the central bank effectively ‘prints’ money by buying financial assets, adding them to its balance sheet to stimulate the economy, creating inflation and demand.

Too accommodative monetary policy can create bubbles in assets, such as property, bonds and equities, since bonds’ yields decrease, borrowing is cheap and ample liquidity pushes asset prices upwards. The risk is when bubbles deflate.

During past economic cycles, some claimed, ‘this time is different’ and the economic cycle is dead. For example, during the expansion at the end of the 1990s, in the build-up of the high-tech bubble, some declared the economic expansion was to last forever, as the world entered a new digital economy. After the 2008 crisis, some asserted the economic cycle was broken due to QE.

However, ‘this time is different’ are probably the four most expensive words in finance. Each time is indeed different since the specific circumstances are not the same. We have never been here before now. But the economic cycle continues, oscillating amongst its four stages.

The investment clock

Different assets perform differently during different stages of the cycle. Investors can use the economic cycle to rotate amongst asset classes. Imagine a clock with each of the four stages of the cycle at each of its quadrants.

During expansion (between 9 o’clock and 12 o’clock), inflation is rising, GDP growth is above trend and sentiment is positive. The assets benefiting the most are commodities and property. Demand and inflation support commodities. Low mortgage rates and inflation support property.

Equities should perform positively, but they are becoming expensive. Government bonds suffer due to rising inflation. High yield should perform well due to carry and steady spreads. Local currency tends to appreciate due to expectations of rising rates, so hedge foreign currency.

During slowdown (between 12 o’clock and 3 o’clock) GDP growth falls below trend, inflation is still rising and sentiment begins to vanish. Commodity prices start falling due to weaker demand. Equities struggle since they start pricing in the fears of a looming recession and they are expensive. Volatility intensifies.

Inflation-linked bonds should perform well, as inflation is rising above expectations. IG credit and high yield suffer due to inflation and concerns about corporate profitability.

During recession (between 3 o’clock and 6 o’clock) GDP growth falls below trend, inflation is dropping and sentiment is shattered. The assets benefiting the most are government bonds (govies) and cash. Falling inflation and interest rates support govies. Cash outperforms when risk assets lose value.

Equity markets fall. Large cap and growth stocks tend to outperform small cap and value stocks during contractions.⁴ Local currency tends to depreciate, depending on how foreign economies are faring. Investing in strong overseas assets and currencies is an opportunity.

During recovery (between 6 o’clock and 9 o’clock) GDP growth rate moves above trend, inflation is still low and sentiment turns around. The assets benefiting the most are equities and spread products. Economic growth and improving sentiment support equities, which are attractively priced. Wide spreads of spread products narrow due to improving economic conditions.

Govies lag since they are expensive and the market starts to price in expectations of higher rates.

This is a stylised description of how assets should behave across stages of the cycle. Real life is full of surprises, though. Often, assets misbehave, drifting away from expectations.

Summary

• The economic cycle rotates amongst expansion, slowdown, recession and recovery.
• Correctly identifying the current stage of an economic cycle and predicting the next one is challenging, in particular forecasting inflection points between regimes.
• Different assets behave differently during different stages of the economic cycle. By forecasting to which stage the economy is heading you can rotate your portfolio to better performing assets.

Notes

¹ Wealth effect is changes in demand of consumers due to changes in the value of their assets, such as stocks, bonds and property. Increase in the value of assets leads consumers to feel more confident and wealthy, encouraging them to spend more, dampening savings.

² Fiscal deficit is the difference between a government’s expenditures and revenues, excluding borrowings.

³ Central banks can justify focusing on unemployment as part of setting monetary policy. The Phillips curve inversely links unemployment rates with inflation rates. Decreased unemployment in the economy tends to correspond with higher inflation rates.

⁴ The opposite tends to occur over expansions: small cap and value stocks tend to outperform large cap and growth stocks. Since expansions are typically longer than contractions, small cap and value stocks tend to outperform large cap and growth stocks over the entire cycle.