SprottWealth Insights

The Business Cycle

What a roller-coaster ride August and September have been. August saw the Dow Jones Industrial Average plunge by 6.6% and the S&P 500 fall by 6.3%, their biggest monthly percentage drops since May 2010 and May 2012 respectively1. Anxiety about China’s slowing growth, a looming September Fed rate hike (that ultimately did not come to pass), and plummeting oil prices (crude oil slid below $40/barrel) were the main contributors to the sell-off. Are we seeing the beginning of a new bear market or merely a correction? Is the volatility finally over or has it just begun? 

The Fed met last week to discuss raising rates for the first time in nearly a decade. They ultimately decided that in light of a global slowdown, and low levels of inflation in the US, the economic climate was not right to increase rates. However, a rate increase is coming – the question is when. Fears about China have not disappeared completely – manufacturing in the world’s second largest economy has slumped to 6 ½ year lows2. In a surprising move, China devalued the yuan in August which points to Beijing’s concerns about the slowing pace of growth. The devaluation of the yuan sparked competitive devaluation of both the Vietnam dong and the Kazakhstan tenge3. Weakness in China will potentially affect commodities significantly, along with other industries in which China is an important end-user. Continued anxiety about these macroeconomic conditions will likely mean continued volatility for some time. Given the expectation for more market volatility going forward, it seems appropriate to discuss the four phases of the business cycle this month.

It is important to note that the characteristics of each phase discussed below are based on historical observation, and are in no way a guarantee of future behaviour.

What is the Business Cycle?

The business cycle refers to the recurrence of four stages of expansion and contraction in economic activity. It may also be called the boom and bust cycle. The goal of economic policy is to achieve healthy growth and stability. The rate of growth should be fast enough to create jobs for everyone who wants one but slow enough to avoid excessive inflation. To achieve this, the government uses both fiscal policy, which is the use of government spending, borrowing and taxation to regulate growth, and monetary policy, which is the use of interest rates, exchange rates, bank reserves and money supply to influence consumer demand and control inflation. Unfortunately, many factors can cause an economy to contract. The four phases that each cycle moves through are: expansion, peak, contraction, and trough.

 

The business cycle 

Expansion Phase 

As the name suggests, this stage is characterized by a steadily expanding economy. During the expansion phase, inflation stabilizes and increasing demand is matched by concurrent increases in production resulting in growing corporate profits. Job creation is steady and the unemployment rate is steady or falling. Real GDP (i.e. excluding the effects of inflation) rises during an expansion and consumer confidence is high. The expansionary phase of the business cycle is reflected in the markets by rising equity prices. A prolonged rising trend in equity prices is called a bull market. Cyclical stocks (such as commodity and technology stocks) are highly correlated to the economy, so during this phase, they tend to outperform. A hallmark of the latter stages of the expansion phase is an uptick in speculation. This usually happens just prior to the peak. For example, the 2001 Tech Wreck was preceded by meteoric rises in dot-com stock prices. Similarly, the 2007-09 Great Recession that saw nearly 9 million jobs lost followed a period of unparalleled speculation in the U.S. housing market.

 

Peak Phase

The top of the cycle is called a peak (market top) and it is the point of the business cycle that represents the maximum financial risk. The economy tends to function near full capacity in this phase and the economy’s expansion slows. When demand outpaces supply, the economy overheats, product shortages occur and inflation increases. Inflation erodes the value of our currency. As inflation rises, in an effort to keep it under control, theoretically, the Bank of Canada will raise interest rates. Borrowing becomes more expensive, which reduces business investment and the sale of big-ticket consumer goods and houses. Rising interest rates cause bond prices to fall. As consumers have less money to spend, sales decline which results in accumulation of inventory and reduced profits. Reduced profits cause stock prices to fall and stock market activity to slow.

 

Contraction Phase

When an economy passes its market top, it enters a downturn. During the contraction phase, real GDP decreases. Companies produce fewer goods because they are faced with surplus inventory and falling profits. They may also attempt to minimize overhead by laying-off employees. As a result of the rising unemployment, discretionary income erodes and spending decreases. Due to low consumer confidence, consumers limit non-essential spending, which further cuts into sales, fueling the contraction further. Equity prices fall due to reduced corporate profits. A prolonged decline in equity prices is called a bear market. Defensive sectors (such as utilities and health care) tend to outperform in this phase.

 

Trough Phase

It is during this phase of the business cycle that the market bottoms out. It may not seem like a good thing, but a trough actually marks the economy’s transition from contraction back into expansion and represents the point of maximum financial opportunity in the cycle. Falling demand limits the ability of companies to raise prices and causes inflation to fall and unemployment rates to remain high. In an effort to jump start the economy; theoretically, the Bank of Canada will lower interest rates. Lower interest rates reduce the cost of borrowing and encourage greater capital investment. Consumers who curtailed spending during the contraction will be spurred by lower interest rates and begin to spend on big ticket items. Companies that reduced production during the contraction will increase production to meet new demand. Lower interest rates will trigger a bond rally. Increased production, corporate earnings and renewed consumer confidence will cause stock prices to begin to recover. When the economy rises above its previous peak, it has entered a new expansion phase.

 

So... what phase are we in right now?

That’s a great question! The answer is… no one can be 100% sure, but we can make an educated guess based on economic indicators. They suggest that we are in the latter stages of an expansion phase. You may be confused – data released recently by Statistics Canada showed that Canada’s economy suffered two consecutive quarters of contraction in the first half of 2015 (real GDP declined). So, how could we still be in an expansion phase?

Take a second and refer back to the chart above. While the curve looks smooth, the reality is that there are several ups and downs along that curve. As a result, while the predominant trend of the expansion phase is upward, when you zoom in on that phase, the ride can look a little bumpy.  While GDP declined in the first half of the year, weakness in the economy was contained mainly in energy and other industries that were affected by low oil prices. There are economic indicators other than GDP to consider, such as job creation, spending on big-ticket consumer items and many more. Remember – the peak of the cycle is the point of maximum financial risk. As we are likely in the latter stages of an expansionary phase, the peak may come in the next year or two. Now is the perfect time to talk to your SprottWealth advisor about protecting your downside. 

 

1 http://www.usatoday.com/story/money/markets/2015/09/01/wall-street-braces--stormy-september--dow-down-300-points--weak-china-data/71503236/
2 http://www.businessinsider.com/the-latest-economic-data-out-of-china-is-another-disappointment-2015-8
3 http://business.financialpost.com/investing/global-investor/markets-are-falling-around-the-world-as-growth-fears-wallop-stocks-oil