Economic cycle analysis
The rise of economic cycles occurs at different times, with different durations and amplitudes, in all countries of the world.
Even the major developed countries are moving from prosperity to recession and return to prosperity again.
Emerging economies tend to have more volatile cycles because their economies are not as diversified as a developed market. In some countries, economic declines have persisted for many years and even decades.
The business cycle is measured using the gross domestic product (GDP), which is the level of production in a country.
The GDP of a nation is never stable, it grows rapidly, more slowly, or contracts..
THE CYCLE OF GDP IS SHOWN BY USING A DIVIDED WAVE IN FOUR STEPS
Prosperity
Contraction
Recession
Expansion
After the contraction that leads to a recession phase, growth begins again, leading to the expansionist phase.
The phases of the economic cycle are characterized by changes in employment, industrial productivity and interest rates.
Changes in asset prices sometimes precede the stages of the business cycle, and sometimes they move with them.
As a result, the business cycle provides a method of tracking and forecasting economic activity and making appropriate asset class investments.TEPS
.
Prosperity
Economy is strong, the job market is doing well.
Demand for products and services is increasing.
At some point, demand outstrips supply, leading to higher general consumer prices (inflation).
As prices rise, people demand higher wages and more profits.
As the cycle progresses, higher employee costs translate into accelerated price increases for products sold and services offered.
Contraction
When price pressure accelerates, the Federal Reserve raises interest rates to slow economic growth.
Rising borrowing rates are slowing spending by consumers and businesses.
As a result, declining demand leads to slower business growth and prices begin to stabilize.
Recession
If interest rates stay high for too long, demand declines too much and firms reduce their production.
Workers are fired.
Layoffs reduce demand as hired workers start to fear for their own jobs and postpone expenses.
This leads to more layoffs and, ultimately, to a real decline in domestic production.
Expansion
The Federal Reserve facilitates credit by lowering interest rates.
Demand begins to rise again when prices become low and borrowing costs decrease.
Increasing demand requires a greater supply of goods and services.
Companies are hiring, people are becoming optimistic, spending is increasing and the cycle is starting again.
When the business cycle does start slowly , there can be disastrous consequences. The Great Depression between 1929 and 1932 in the United States, resulted from too rapid growth in the 1920s.
High inflation and low unemployment, combined with a series of illegal taxes imposed by Congress on its trading partners, has put the country into a prolonged recession better known as the Depression.
The country emerged from the depression in the early 1930s after a massive government borrowing and spending program.
Governments manage their economies in two ways
Government-run fiscal policy (taxes and expenses) and The Federal Reserve manage monetary policy (interest rate adjustments).
If inflation seems to be rising too fast, the Federal Reserve may decide to raise interest rates to reduce spending by consumers and businesses.
In addition, the president, with the Congress, may also decide to raise income taxes to pull the money out of the economy and deter companies from expanding and hiring more workers.
On the other hand, if the economy is performing poorly, the Federal Reserve can cut interest rates and the government can cut taxes to boost spending and increase business investment..
Interest rates play a very important role in shaping economic activity.
Changes in borrowing costs are also reflected in share prices.
Companies must pay more to borrow money for equipment and to finance daily business operations.
Individuals pay more for mortgages as well as other loans to buy products such as cars.
The higher cost of borrowing reduces the money available for spending in other sectors of the economy.
This slows overall economic growth and slow the stock market.
In addition, as interest rates rise, investor preferences shift from uncertainty in stock returns to higher interest rates on bonds.
This puts additional pressure on stock prices.
Stock market and economic cycle
Understanding the economic cycle is a key element in making macroeconomic decisions about asset allocation.
There are times better than others to invest in stocks, bonds or commodities.
If you can predict where an economy is in the economic cycle, and when the cycle will move, you can manage a portfolio accordingly, and potentially outperform a passive strategy.