On your bike ─ all aboard the economic cycle

1st October 2010

The economic cycle is the natural fluctuation of an economy between periods of expansion and contraction. This slow rotation from growth to recession normally takes several years to turn full circle. 

Pinpointing exactly where we are in the cycle is a tricky business. The only way to tell is to look at the key economic indicators like GDP, interest rates, the level of unemployment and consumer spending.

This is a crucial area for investors as the economic cycle plays a big role in determining the performance of different asset classes. The Enterprising Investor Forum has a graphical illustration of how it all works.

More cycles than Halfords…

Simon Ward, chief economist at Henderson Global Investors, says that there are several different economic cycles. "The shortest one is the Kitchin cycle, which lasts three to five years and describes the process of stock building."

There is also the Kuznets cycle, which explains the 15-25 year fluctuation in housing construction, and the 54 year Kondratiev cycle that focuses on inflation.

"The last major peak was in 1974 during the oil crisis so you could argue that the long downward trend in inflation through the 1980s and 1990s was the dip in the cycle with the trough coming at the midpoint in 2001.

"This would suggest that we are now in the upward leg, with the next peak scheduled for 2028."

When most people talk about the economic or business cycle they are referring to the Juglar cycle, which lasts for seven to 11 years.

"The US went into recession in 2001 and then again 7 years later in 2008 with both being associated with the Juglar cycle. The last trough was in 2009 which suggests the next major American recession won't occur before 2016," explains Ward.

The Juglar cycle relates to business investment with the pick up in the last few quarters supporting the view that we are now in the upswing. This can help shed light on which asset classes are likely to produce the best returns.

The early stage of the recovery tends to favour corporate bonds and equities. Then as the cycle matures you tend to see higher interest rates, which is bad news for bonds, although equities can still perform well.  

As the cycle peaks so too does inflation and this undermines both equities and bonds.

Ward says that the relationship between the business cycle and asset classes is not as mechanical as this analysis implies and that you have to take into account the valuations.

"I would argue that bonds are highly valued at the moment whereas equities are quite cheap, so they might continue to provide better returns until much later in the cycle than you would normally expect."

New cycle for the world economy

After the deepest and longest recession in post war history it would be logical to think that an extended period of expansion was on the cards. This was the pattern in the 1980s and 1990s when the economy had plenty of slack to grow without creating inflation. 

Keith Wade, chief economist and strategist at Schroders, doesn't go along with this optimistic scenario. 

"Concerns about structural unemployment and the growth of demand suggest we are in for a shorter, more volatile expansion. Constraints on fiscal and monetary policy indicate that the scope for countercyclical policy is limited."

Schroders is forecasting growth for the rest of this year and 2011, but they believe the next recession may be closer than expected.

"With the Federal Reserve now becoming concerned about inflation being too low, the tightening cycle, when it comes, could be very short lived," explains Wade.

He thinks the expansion of the economy could end in December 2012 with the next recession starting in January 2013. Monetary policy would move in line with this, with the tightening beginning in September 2011 and drawing to a close a year later.

"Inflation is not likely to be a problem as the short period of expansion will make little impact on unemployment. Indeed deflation could be the bigger worry given the low starting level of inflation."

A period of slower, but more volatile growth would suggest that equities would require a higher risk premium relative to cash or government bonds.

"Some western companies may escape the limitations of their domestic economic cycles by tapping into overseas demand, particularly in the emerging markets where growth should be stronger and more consistent."

What it all means for fund investors

Adrian Lowcock, senior investment adviser at the IFA Bestinvest, says that the difficulty is in the timing and predicting when an economy moves through the cycle.

"A good stock picker can minimise the impact of the economic cycle as the fund manager follows the trends, buying and selling the right companies at the right time. It is the specialist areas like commodity or property funds that will be more affected."

He stresses how important it is that investors appreciate the way different asset classes perform, as this can help to manage their expectations and to avoid investing at the wrong time.

"With the right advice and portfolio planning investors can concentrate on the long-term, whilst protecting themselves from short term volatility and cycles."

The key to this is diversification. A good mix of investments would include: UK and international shares, quality and high yield bonds, commodities, commercial property and absolute return funds.

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