Dissecting the Business Cycle

Dissecting the Business Cycle

As Published in the Shore 2014 Edition of NJ Lifestyle

UNDERSTANDING AND EVALUATING THE BUSINESS CYCLE CAN OFFER valuable information in formulating expectations for the economy and your optimal portfolio allocation. The business cycle is defined as fluctuations in GDP (Gross Domestic Product) in relation to long-term GDP trend growth. The typical cycle usually lasts 9-11 years and can be broken down into five phases, starting with an initial recovery and ending with a recession.

The initial recovery is the phase of the business cycle where the economy starts to pick up from its previous slowdown or recession. Often times this phase is accompanied by easy monetary policy in the form of low interest rates and/or a budget deficit. Business confidence starts to pick up as can be seen with higher inventory purchases, while consumer confidence may remain low as the unemployment rate is high. Inflation during the initial recovery continues to fall, putting downward pressure on government bond yields and the gap between long-term GDP trend growth and actual GDP remains large. As fears of a longer recession subside, the stock market may rise substantially with investors attracted to the riskier assets of small caps, emerging markets, and high yield bonds.

As confidence builds and the economy gains momentum, the early upswing stage of the cycle begins. With increasing confidence, the economy sees consumers increase their borrowing, as rates are low, and increase their spending. Consumer spending constitutes approximately 70% of GDP, so an increase in consumer spending is important to the overall health of the economy. Businesses are leaner, more efficient, and begin to increase capital expenditures as sales rise. With costs low, profit margins expand. The stock market continues to trend upward and short term interest rates should begin to move higher as monetary policy starts to tighten. With inflation remaining low, the economy is given a chance to rapidly expand without getting overheated. Inflation remains a key variable in how long this stage of the business cycle can last, and plays a role in the strength of the overall economy. This stage can last for several years depending on how fast the GDP gap closes.

The late upswing stage of the cycle sees the GDP output gap closing and the threat of the economy overheating. Equity markets are still rising, although they become volatile as investors become nervous. With unemployment low, wage inflation picks up with the development of shortages in labor. Consumer confidence remains high while business profit margins begin to get squeezed. Bond yields tend to rise as monetary policy becomes more restrictive. The Central Bank is tasked with cooling the economy, at this stage, by ushering
in a soft landing, which is classified as a period of slower economic growth, to avoid a major downturn.

With a slowing economy, the business cycle enters the slowdown stage. Business confidence starts to fall and businesses begin to reduce their inventory levels. Slower purchasing orders, as a result of this inventory correction, tend to further add to the slowdown. High interest rates and a continuing rise in inflation leave the economy vulnerable to a “shock” which can turn a soft landing into a recession. Bond yields peak during this stage and then fall sharply. Equity markets may fall during this stage with utilities and financials performing best as they are interest-sensitive sectors. The slowdown stage of the business cycle can last anywhere from a few months to a few years.

Once GDP declines for two successive quarters, the economy has officially entered a recession. Business confidence declines with businesses largely cutting back on inventory and investment while profits fall. Falling profits can cause the unemployment rate to quickly rise as corporations look to cut costs. Consumer spending falls in a recession, leading to lower inflation. As seen in 2009, a severe recession can lead to an increase in bad debts, which hampers the recovery as lenders become more cautious. With the recession underway,the Central Bank begins to ease monetary policy in order to stimulate the economy. As a result, short term interest rates and bond yields will fall. The stock market will fall during the beginning stages of a recession; however, the markets will start to rise again before a clear recovery emerges.

Although the five stages of the business cycle have identifying characteristics, pinpointing where the economy is positioned in each cycle, and how long the cycle will last, remains a difficult task for economists. Currently, GDP growth is still operating below the United State’s long-term trend while inflation remains subdued at 1.5%. The unemployment rate remains high at 6.3%, but has come down a long way from the 10% peak in October 2009. Interest rates remain historically low and may stay low for the next few years as the Central Bank slowly unwinds quantitative easing. With the market continuing to reach new highs, the economy appears to still be on the upswing.

Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
Co-Managing Partners – CRA Financial

Robert T. Martin, CFP®
Investment Advisor

This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.