Where are we in the business cycle?
Activity in the financial markets are heavily influenced by the business cycle. This is because monetary policy, corporate earnings, consumer spending, inflation and many other market relevant factors are influenced by changes in the economy. As we pointed out a recent post, understanding where we are in the cycle and where it is going can give us a better idea of what types of investments are likely to perform well in the coming months and years. Therefore, knowing where the cycle is headed can inform our investment decision making process.
Our discussion today will focus on learning a little more about the business cycle, its four phases and identifying individual economic indicators that we can look to as confirmation of our relative position in the cycle. In our work, having this knowledge is important because it lays the foundation for our broader market narrative. A market narrative is the story we tell explaining where we believe the market is headed and why.
Focus on a framework
In order to develop a market narrative, we require a proper framework for putting together all the relevant economic and market developments into a cohesive story. As discussed earlier, a macroeconomic-based approach takes a top-down view on the markets, uses the economy as our guide and focuses our narrative on an understanding of how changes in the business cycle may affect the markets and our investment decision making process. In other words, the story we’re telling happens to be our belief about how the markets may favor certain assets given where we expect the economy to be headed in the future.
Understanding the current economic environment, that is, where we are in the business cycle, is the first step in fleshing out a broader market narrative framework.
Current economic environment: the business cycle
In some years jobs are plentiful and in others they are not. One moment a firm’s earnings are flying high and in the next bankruptcy is on the horizon. These things happen simply reflect what can happen as the business cycle ebbs and flows through time.
But what is a business cycle? Simply put, a business cycle represents the variation through time of investment and spending activity within an economy. That is, “activity” represents the individual choices that you, me, the CEO down the street and many others make regarding how we spend our money daily.
When we’re feeling confident about the future, we tend to spend more today and less so when uncertainty lies ahead. From an investment perspective, we are concerned with the variation in this activity at a national level, so we’re looking at the present (and potential) choices that individual actors as a collective are making.
Ebbs and flows in the business cycle
Let’s take a further look at how the business cycle can ebb and flow through time. We break down this cycle into four periods:
- Expansion: the economy is steadily growing; businesses and consumers feel more confident; households increase discretionary spending as labor market conditions improve and corporate earnings rise; the economic trend is moving higher.
- Peak: the economy is doing very well; business and consumers are extremely optimistic; household spending and business investment activity accelerate while unemployment rates head toward cycle lows; the economic trend is leveling out and pointing to a slowdown.
- Recession: the economy is no longer doing well; confidence has faded precipitously; household spending is exhausted; businesses are increasingly reluctant to engage in capital investment activity.; the unemployment rate moves higher; a slowdown is giving way to an economic contraction.
- Recovery: the economy is finding its footing; unemployment continues to move higher before leveling off; households and business confidence moderate leading to a modest spending and investment rebound; economic activity is rebounding after having contracted.
Components of economic activity
Measuring the choices through time of individual economic actors is hard. Fortunately, statisticians and economists at government institutions collect this information on a regular interval, making the data is made freely available to investors. Gross domestic product (GDP) represents the collection of this individual data and reflects total spending in a national economy. These expenditures are generally grouped into four broad categories:
- Personal consumption expenditures: total individual and household spending on everything from the coffee we buy to our auto and mortgage payments.
- Private investment: statisticians break up this category into two areas: a) construction activity and b) spending by private businesses on things like new equipment, business expansion and development of new technologies.
- Government spending: municipal, state and national government spending and investment activity are collectively captured in this category, typically broken down between mandatory (like social security and healthcare) and discretionary (defense) spending.
- International trade: in a globalized economy there are things that one country is more efficient at producing over another and therefore it exports these goods to the rest of the world. In other instances, there are things that a country may find cheaper to source from the rest of the world and therefore it imports them.
Taken together economic growth represents a collective expansion within these components of GDP.
GDP: One part of the business cycle
Data from the Bureau of Economic Analysis shows that the size of the U.S. economy (as measured by GDP) has steadily increased since the end of World War 2. In fact, total spending in the U.S. has increased by a factor of 9 over this 70-year period, averaging growth of 3.2% per year. Looking at the chart above, we can see that this growth has not been uniform and indeed there are times where the amount of spending decreased around periods of recession. The business cycle therefore represents the recovery from a recession, expanding activity which peaks and finally leads back into a recession that occurs between the gray bars in the chart.
Defining the business cycle
We define a business cycle by measuring actual GDP activity against some sort of benchmark. A commonly used baseline is a measure known as potential GDP. The calculations for this measure are beyond the scope of this discussion, but an interesting read from the IMF can be found here that gives more detail on it. Nevertheless, potential GDP simply represents the maximum amount of economic activity given an estimate of efficient use of labor and investment in the economy.
With this baseline in hand, we can then calculate what’s known as the output gap. The output gap is a ratio of actual GDP versus potential GDP. When economic times are good, the output gap is positive which suggests that the economy is producing at a rate much faster than the estimated maximum amount of output for the economy. Such trends mark the expansion and peak phase of a business cycle.
On the other hand, a negative output gap suggests that output is coming in below that potential and marks the recession and recovery phase of the business cycle. This information is typically used by policymakers to set monetary and fiscal policies to either help activity in the economy reach its potential (recovery phase) or help cool an economy that appears to be overheating (peak phase). As investors, we use this information about the trends in the cycle to identify investment opportunities that may coincide with the direction of the economy.
Measuring the cycle
When activity remains above potential for overheats for too long (overheats), policymakers tend to step in to help bring growth back in line with its potential. This typically means that central banks, like the Federal Reserve, will tighten policy by increasing short-term rates, raising borrowing costs for households and businesses.
This action can tip the economy into a slowdown and eventually the recession phase of the cycle. The National Bureau of Economic Research defines a recession as “…a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
According to data from the NBER, the U.S. economy has been through 11 such expansion and recession type cycles since 1945. The average length of a cycle, as measured from its recovery to peak is about 5 years. However, history shows that the cycle can be as short as one year as in 1981 or as long as 10 years which marks the current cycle that we’re in today (as of April 2019). Regardless of their age, what is consistent about business cycles over the course of time is that they start from a position of recovery, move through an expansion, eventually peak and fall into a recession.
Indicators consistent with a cycle
Outside of the output gap as a measure of the business cycle, we can look to individual components of activity in the economy that help us confirm what stage the business cycle may be in. These components include:
- Consumer confidence
- Wage growth
- Unemployment gap
- Consumer borrowing standards
- Corporate borrowing standards
- Corporate profit growth
- Business sentiment
- Corporate assets
- Business inventories
One way to determine which phase the current cycle is in (and likely headed to) is by asking whether measures of these components are more consistent with the recovery, expansion, peak or recession phase. The table above summarizes our findings regarding the evolution of indicators throughout the business cycle. The chart below provides a visual for how these indicators tend to coincide with the ebbs and flows of the business cycle and provide a sort of confirmation of our position in the business cycle.
What’s next? Figuring out the expected economic environment
An assessment of the current economic environment gives us an idea of where we are in the business cycle. This is an important first step in the investment decision making process as it gives us a point of reference for determining where the cycle may be headed.
In our next post on developing a market narrative, we’ll talk more specifically about how we develop economic forecasts that can give us a better idea of where the business cycle may be headed. Knowing this is important because we can position our investment portfolios in anticipation of transitions between the different phases to preserve capital or gain an extra edge on markets.