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Understanding business cycles and their impact on asset classes
THE recent inversion of the yield curve (a rare scenario when the short term yields are higher than long term yields) has been a talking point as a precursor of transition of business cycle from a prolonged growth era to a looming recessionary period. Well, what goes up must come down - and business cycles are possibly no exception to this rule. Economies often fluctuate in cycles - recovery, expansion, peak and recession. And this is repeated over time.
There are many factors which influence the investment markets and impact returns on investments. Business cycle change is perhaps one of the most influential factor among these, as the cycle changes represent the state of economic growth (whether expanding or contracting), corporate earnings (profits and job impact), credit cycle (ease of borrowing) and inflation (price changes).
This article aims to explain the different phases of a business cycle and their impact on asset classes.
What are business cycles?
Like two extreme sides of a day (midday to midnight), a business cycle has two extreme states (peak, represented by economic activity in full bloom and trough, represented by recession). To account for smooth transition, the entire business cycle can be divided into four stages.
Unlike market cycles, which are largely driven by sentiments and hence shorter, business cycles typically last longer between five to 10 years.
Peak (key outcome - slower growth rate)
This phase occurs when the economic activity has peaked and growth begins to moderate. While growth is still positive, it starts to slow down in terms of pace of growth. Corporate earnings and profit margins start to get compressed due to tighter labour market, rising wages, costs, interest expenses and continued inflationary pressure. This leads to a slowdown of business momentum. This also results in tightening of the credit market making it difficult for corporates to access loans. Though unemployment rate continues to fall, it does so at a decreasing rate. As you can visualise, we are possibly in this phase of the business cycle.
Recession (key outcome - contraction)
Post the period of peak economic activity, businesses start to slow down, as a result, start to freeze pay, reduce hiring or even embarking on layoffs resulting in higher unemployment rate, which, combined with lower wages results in decreased consumer spending.
Inflation rate starts to retreat, corporate profits decline and credit market dries up. Central banks start to adopt an accommodative monetary policy, and as corporate inventories start to reduce, this sets up the path for a recovery.
Recovery (key outcome - early expansion)
With the aid of accommodating monetary and fiscal policies, lower prices and rising production, Gross domestic product (GDP) starts to stabilise. Though unemployment rates may still be high, layoffs start to slow down. This brings a dramatic change in the spending pattern which is most pronounced in housing and durable goods. Inflation remains moderate and continues to fall.
This also marks the inflection point with momentum moving from negative economic activity to positive. Credit conditions stop tightening amid easy monetary policy, creating an environment for margin expansion and profit growth. This marks one of the best periods of economic growth.
Expansion (key outcome - late expansion)
During this phase, which is typically is the longest phase of a business cycle, economic activity shows continued acceleration. Unemployment rate starts to fall as corporates resort to increased rehiring with possible wage increase.
Consumer spending starts becoming more broad-based. Inflation continues to be modest, keeping a healthy margin for corporates. Corporates reinvest their profits into expansion which helps the equipment manufacturers and construction sector.
Credit growth becomes stronger as a reflection of strong profitability further helping expansion and improved sales.
Different asset classes tend to behave differently in each of the phases of business cycle.
How do we know which cycle are we in?
There are a few questions we can ask to assess which phase of the business cycle we are in:
- Are corporate earnings growing or decreasing?
- Are businesses expanding or contracting?
- Is the GDP growth rate increasing or slowing down?
- Is inflation moving up or down? Are prices rising or falling?
- Are central bank monetary policies accommodative or restrictive?
What are my next steps?
It is important to note that different countries may be in different phases of business cycle. Also, there is never a clear demarcation of the changes in the phases of the business cycle and often these transition periods are blurred.
It is best to maintain awareness of what is happening in the business environment and continually review your portfolio on a periodic basis to assess any impact or actions based on changes in the business cycle apart from your own personal circumstance.
As evident, different asset classes perform differently during various phases of business cycles, it is good to follow a strategy of diversification across multiple asset classes, to help manage the market risk through these phases of business cycles by not being over-concentrated in any one particular asset class. It is always good to have a long term perspective while taking investment decisions and avoid short term market noise or emotional decisions. Seek professional guidance where possible.
Disclaimer: This article is intended for education purposes only and does not constitute investment advice or any recommendation. Views expressed are of the author alone and do not represent any organisation.
- Deepak Khanna, CFA, is the Head of Wealth Development with HSBC Bank (Singapore) Ltd