#6) The 5-Phase Business Cycle
Key Takeaways:
Currently, as of July 2023, it seems we are in a “Late Expansion” and slowly approaching an “Economic Slowdown”
We can use the business cycle to gauge the overall markets and when a recession is looming is a good indication to turn to cash and reduce exposure to certain asset classes
I was recently working on another installment of the “How Macroeconomic Factors of SPY Impact Your Trading” series, relating to yield curve inversions, and had to take a step back to first explain a broader topic in order to add more context to the upcoming post on yield curves and spreads.
One thing I wanted to reiterate before jumping in. As a retail trader, really the only goal is to make a profit from the market... nothing is above this. This post may be less related to this one and only goal, HOWEVER, the context to understand why business cycles are important and why they may impact your trading will come later. But, you can probably already figure out that determining when a recession is looming is a good indication to turn to cash and reduce exposure to certain asset classes. Now for shorter-term traders, these concepts may not be needed, as a more simplistic approach to exposure reduction can be used, however, I believe it is still a useful tool in the toolbox to have. I believe there is a lot of knowledge to be gained in understanding the stages of the business cycle as they relate to the real world!
Investopedia's Explanation of Business Cycles:
As Investopedia puts it, business cycles are a type of fluctuation found in the aggregate economic activity of a nation -- a cycle that consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions (recessions). This sequence of changes is recurrent but not periodic. These cycles are marked by the alternation of the phases of expansion and contraction in aggregate economic activity, and the comovement among economic variables in each phase of the cycle. Aggregate economic activity is represented by not only real (i.e., inflation-adjusted) GDP—a measure of aggregate output—but also the aggregate measures of industrial production, employment, income, and sales, which are the key coincident economic indicators used for the official determination of U.S. business cycle peak and trough dates.
The Scary "R" Word (Recessions)
A popular misconception is that a recession is defined simply as two consecutive quarters of decline in real GDP. Notably, the 1960–61 and 2001 recessions did not include two successive quarterly declines in real GDP.
A recession is actually a specific sort of vicious cycle, with cascading declines in output, employment, income, and sales that feedback into a further drop in output, spreading rapidly from industry to industry and region to region. This domino effect is key to the diffusion of recessionary weakness across the economy, driving the comovement among these coincident economic indicators and the persistence of the recession.
I will be using the CFA Level 3 program to explain these 5 business cycles as they help to shed light on what it is like in the real world. It is one of the most comprehensive phase cycles I have seen so far.
5-Phases of the Business Cycle:
They explain that for the purpose of setting expectations for capital markets, a five-phase business cycle is used. The first four (#1,2,3,4) occur within the overall expansion. They are:
1) Initial Recovery
Short phase after the trough/contraction of the cycle
The economy picks up, business confidence rises
Stimulative policies are still in place, negative output gap is large
Inflation typically decelerating
A recovery supported by increased spending on housing and consumer durables
Capital market effects:
Short-term rates and government bond yields are low
Bond yields may decline in anticipation of further disinflation, possibly bottoming
Stock markets may rise briskly as recession fears dissipate
Investors are attracted to cyclical and riskier assets, such as small stocks, higher-yield corporate bonds, and emerging market equities and bonds
2) Early Expansion
The economy gaining momentum, unemployment starts to fall
Output gap remains negative, consumers borrow and spend
Businesses increase production and investment, profits rise rapidly
Strong demand for housing and consumer durables
Capital market effects:
Short rates begin to rise as stimulus is withdrawn
Longer-maturity bond yields stable or slightly rising, yield curve flattening
Stocks trend upward
3) Late Expansion
Output gap closed, economy at risk of overheating
Boom mentality prevails, low unemployment, rising profits, wages, and inflation
Capacity pressures boost investment spending, potential deterioration of debt coverage ratios
Capital market effects:
Interest rates rise as monetary policy becomes restrictive
Bond yields rising, yield curve flattening
Private sector borrowing pressures credit markets
Stock markets often rise but may be volatile
4) Slowdown
The economy slowing, approaching peak due to rising interest rates and accumulated debt
Vulnerable to shocks, wavering business confidence
Inflation continues to rise as firms raise prices
Capital market effects:
Short-term interest rates are high, possibly still rising but likely to peak
Government bond yields top out and may decline sharply
Yield curve may invert, credit spreads widen
Stock market may fall, interest-sensitive and stable-earnings "quality" stocks perform best
5) Contraction
Lasts 12 to 18 months
Investment spending leads the contraction
Firms cut production sharply
Central bank eases monetary policy after recession confirmation
Profits drop sharply, credit tightening magnifies downward pressure
Capital market effects:
Short-term interest rates drop, as do bond yields
Yield curve steepens substantially
Stock market declines in early stages, starts to rise before recovery emerges
Credit spreads widen and remain elevated until signs of a trough emerge
Conclusion:
Understanding business cycles and their impact on the economy is a crucial tool for traders and investors alike. While the primary goal for retail traders is to make a profit, being aware of the different phases of the business cycle can provide valuable insights for making informed decisions in the financial markets.
References:
Investopedia - Business Cycles - This gives a good base understanding
CFA Curriculum - Explanation of the business cycles